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By Sarah Klein — Published June 14, 2018
Have you ever heard the phrase "shorting a stock" and wondered what exactly it meant? Perhaps one of the easiest ways to explain the financial concept of "shorting" is via a real-life example that is portrayed in a 2015 Academy Award film that grossed $133 million in the box office. In fact, the term "short" is even included in this film's title.
What is Short Selling?
The Big Short is a 2015 biographical film about the 2007-2008 financial crisis that was triggered by the housing bubble in the United States. In it, we see how separately, a number of people begin to realize that something is very wrong with mortgage securities and in particular the subprime market. As Wall Street banks, regulators, and rating agencies continue to deny and cover up the issue that would undoubtedly lead to massive economic collapse. The film does a good job of introducing a number of economic concepts, though the jargon can get confusing at times.
Shorting a stock is essentially betting that a stock (or other securities) will fall in price. This is what The Big Short's protagonists do when they realize that the housing bubble is just that -- a bubble -- and that it's set to burst. For example, investor Michael Burry predicted the real estate collapse would occur in 2007 and decided to "short the market." Banks thought the protagonists were crazy since the mortgage market had always been seen as stable and believed it could not take a hit. Of course, we all know what happened. Those who decided to short the housing market, betting against it, ended up making millions.
How to Short a Stock
When short selling, you are actually selling something that you don't own. First, you borrow stock from someone who owns it, agreeing to pay a fee to the broker lending you the stock. After borrowing the shares, you sell them with the idea that when the price falls, you can buy them back and pocket the difference when returning them to the lender. For example, if you buy 100 stocks for $5,000 and then immediately sell them for that same amount. The next day, you see that those 100 stocks go for $4,000. You buy back 100 stocks, give them back to the original broker, and pocket the extra $1,000 for yourself.
The problem occurs if the price of the stock actually increases. In that case, you would end up losing money when you attempt to buy the stock back. In 1901, there was a railroad bubble, and railroad stock prices rose 25% in one month. This looked over-inflated, so people began shorting it. Unfortunately, the railroad shares actually increased in price from $170 to $1,000 in just a day, bankrupting those who had attempted to short the stock.
When shorting a stock, there is no limit to how much money you could potentially lose. If you purchase a stock the traditional way, the most you could lose is your original investment. Additionally, when attempting a short, you may find that the stock you hope to repurchase may not be available when you want it to be if others are not open to selling at that moment. In other words, it is a big risk. That being said, short selling still accounts for 40% of dollar value traded in the US equity market. If you play your cards right, you could make big money by short selling stocks.