Did you see the movie The Big Short? Based on a true story, it told the story of what happened when several hedge fund managers, investors and one bank salesman shorted the subprime mortgage market.
In the simplest possible terms, these men bet that mortgage holders would default. They made agreements with the banks that if and when the defaults came rolling in, the banks would pay these speculators. When 2008 hit, these guys walked away with millions (and in some cases, billions) of dollars.
But what exactly is short selling? How did these men manage to pull it off? How does one “short” the stock market? And shouldn’t we all be trying to short the market to make millions?
What Is Short Selling?
Most people buy stock with the intention of holding onto it for a long period of time. This is called “going long.”
“Going short” is when you sell fairly quickly after buying your stock. And a short sale is a specific sale that tries to capitalize on an asset perceived to be about to lose value.
Short selling is both simple and slightly complicated. Here’s how it works.
Traders borrow stocks and sell them at current market prices and receive the cash. They make an immediate bit of money, but they have only borrowed the stocks, so they need to 1) replace the stock at some point in the future and 2) pay dividends out of their own pockets for the length of borrowing the stock.
People who short sell are looking for the stocks they’re borrowing to tank. They want them to go belly-up so that they can buy the stocks back at a far reduced price and replace their borrowed shares and take home the difference. The hope is that the difference will be enough money to make it all worth it.
Here’s an Example
If a trader thinks that a certain stock is going to lose money, they’ll target it for short trading. So let’s say that Susan thinks that XYZ Company stock is going to lose value over the next year because of negative reviews and high prices.
Susan borrows 200 shares of XYZ Company at its current market value of $40 per share. She sells them for $8,000 and receives the cash. However, this scenario isn’t done. Depending on what happens with the market, Susan could be headed for either more money or a downfall.
Let’s say the shares go down by 50% in a year. In that year, Susan has had to pay dividends to the people she borrowed from. Susan buys back her shares at $20 a share, for $4,000. Her profit on the short sale (before dividends and commissions) is $4,000. Susan has also now replaced the stock she borrowed.
If Susan guessed wrong and XYZ Company stock goes up, she’ll lose money. Susan has to repurchase the shares at the new higher price so that she can give back what she borrowed, plus she’s had to pay dividends the whole time she was trying to short the stock. Let’s says she had to pay $50 per share. That’s $10,000 she has to pay, and she has now lost $2,000 plus commissions and dividends.
Back to Those Guys From the Movie
What the guys in the movie essentially did was forecast that the way mortgages were being funded was going to collapse. They bought credit default swaps, which meant that they were betting that people would default on their mortgages.
The results of their bets? Charles Ledley and Jamie Mai were two of the men profiled in The Big Short, and they made $105 million in 2008. Dr. Michael Burry made $100 million personally and over $700 million for his clients.
Should You Try Shorting a Stock?
In a word, no.
Short selling is a very tricky game to play. It’s based on speculation. A trader thinks a stock will go down, with no proof that it actually will. And even if the stock does go down, the trader doesn’t know when that will happen. So they could be stuck paying out dividends from their own pocket for a long stretch of time before they make money — and again, that’s if they make money.
Short selling was very good to very few people in 2007–2008. It’s sort of a get–rich-quick scheme. There’s simply no guarantee it’ll work and no way to know anything for sure.
There’s also a moral gray area to short selling. You are betting that something fails, after all. When the stock does lose value, most likely that means that someone is losing their job or at the very least a part of their investments.
Take the case of the men from The Big Short. Yes, they all walked away with millions, but the devastation from that stock market crash and mortgage default situation caused tens of millions of people to lose their homes and their nest eggs. The whole world felt the effect of the US housing market collapsing. For some people, it’s against their moral code to try to profit off of something failing.
Shorting a stock is very different from simply selling stock. It’s a great tactic to know and understand, but in general, something to stay out of.
What Should You Do Instead?
As you can see, shorting stocks is risky business, and we here at Investor Junkie don’t think it’s smart to take undue risks. This is why we’ll never recommend day trading.
If you’re looking for a way to build your wealth, we recommend making steadier, safer choices such as investing in real estate. If this appeals to you but you don’t want to get your hands dirty with the hassles of fixing-and-flipping, there are a number of real estate alternatives out there.
Fundrise is a real estate investing platform that offers a private eREIT (electronic real estate investment trust) for a minimum investment of $500.
We also recommend making an investment in yourself — whether that’s by paying off your consumer debt (and saving a boatload in interest) or by starting your own business.
And if you do decide to “play” the markets, you’re best off to have a broker with low fees but lots of tools to help you make smart decisions. TD Ameritrade charges low fees, requires no minimums and offers a lot of educational extras for investors. (Plus, you can use this service to short sell if you insist.)
Readers: What do you think about short selling and its risks?