“Buy low, sell high.” It’s an investing maxim as old as the stock market itself. It’s pretty straightforward and, if you can follow it, will make you money. So what about “sell high, buy low.” It would seem to give you the same result but it’s not quite that simple. Also known as “shorting a stock,” this strategy is essentially a bet on a company’s share price going down, not up.
You’ve probably heard people talking about shorts many times but how does it work and is it right for you?
We went to an expert, Brad Lamensdorf of the Ranger Equity Bear ETF, to help better explain it all.
“We’re selling something at $20 and we’re hoping it falls to $10 and we’re buying it back and we’re making the money that way as the stock falls.”
Related: Go short: 3 stocks heading lower
But Lamensdorf also explains that it’s not quite that simple. “You can’t just call up and just sell something you don’t own,” he says. “You actually have to call a bank, they lend you the security in your account and you can sell it thereafter.”
In other words, to short a stock you have to borrow it from someone who already owns it. Then you sell it and take that profit. If the stock falls you buy it back at the lower price and give it back to the original owner. You end up with the same profit when it loses $10 as you would if you had traded more traditionally and bought at $10 and sold at $20.
Of course banks won’t just let you borrow their shares for nothing. They demand an interest payment for the right to use those shares.
“If it’s a very very highly sought after short,” Lamensdorf cautions, “where everyone is betting against it, the interest can be upwards of 10, 20 30 percent. I think Sears is up even around 50%.”
That's not the only risk associated with shorting however. Investors need to remember that If for any reason the bank that loaned you the stock begins to run low on shares, they can recall your shares at whatever the price may be that day, potentially forcing you to take a loss.
“Always make sure you have a very secure borrow,” Lamensdorf suggests. “The way to do that is literally to call everyday and make sure [the bank has] plenty of supply to be lending you into your account.”
Finally, one last caution. When you hold a long position on a stock your maximum loss in quantifiable. If you buy one share of a stock at $10 the most you can lose is $10. If you short a stock at $10 and it doesn’t go lower, but instead goes higher, there is theoretically no limit to how high it can go and how big a loss you can be forced to take.
Is shorting worth all these risks? Many investors believe it is. What do you think?