Regardless of the direction of a stock, when the price changes, some will make money while others will lose. The reason for this is the difference between buying long and selling short. Our most common conception of investing in stocks is to buy while the price is low and sell when the price is high. However, there are many investors (typically with a great deal of money at work in the market) that do the reverse - sell high and buy low.
Buying Long
Unless you're an eternal pessimist, buying a stock in the hopes that its share price will appreciate is a good way to invest in the market. After all, stocks have the greatest return of all major asset classes, averaging anywhere from 8% to 17% depending on the timeframe surveyed. Since the odds are generally in the investor's favor over time, buying today and waiting for the share price to increase down the road seems to be a good bet. As a result, the overwhelming majority of investors buy long positions in stocks and hope to receive a good return over a long period of time.
Selling Short
For pessimists and opportunists, selling short is a valuable way to play the market. As noted above, selling short has the goal of selling shares at a high price and buying them back at a low price. This begs the question: How can you sell shares that you don't own? The answer is that you borrow them.
When you open a brokerage account with a company like Fidelity, E*Trade, or Schwab, buried in the fine print is usually a provision that allows the company to 'lend' your shares to other account holders. While you don't really lose possession of the shares, your ownership stake allows a short seller to borrow the shares and sell them in the open market.
During this period where the shares are on 'loan', you won't see any changes on your statement, but the short seller will have a short position in the borrowed stock. During this period of time, the short seller will pay interest to the brokerage company for use of the borrowed stock. These rates can vary greatly, but usually aren't too far from the prime rate (for large accounts, anyway).
If the stock drops as the short seller hopes, he or she will then 'buy to cover' which will close out the position. The proceeds from the sale are then taken against the cost of the purchase plus the interest charges. If the proceeds are greater than the costs, the short seller will make a profit.
Application: Buying Long
As an example, let's suppose we purchase 100 shares of XYZ stock for $20 per share. This means that the shares have a total cost basis of $2,000. A year later, the shares are worth $40 per share. This results in a profit as calculated here:
Application: Selling Short
Taking the same process in reverse, we sell 100 shares of XYZ stock for $40 per share and receive $4,000 in sale proceeds. One year later, the stock has fallen to $20 per share and 100 shares are bought to cover for a total of $2,000 in cost basis. During the holding period, interest was charged in the amount of $180. This results in a profit shown below:
As you can see from these two calculations, the only difference in the math is the added cost of interest for short selling, but it's the same concept for both - sale proceeds minus costs equals profit.
Wrapping Up
From this article, you should remember that buying long is the most prevalent method of investment in the stock market. This has many reasons, but the best one is that the market pays quite well over time. Short selling is simply the reverse of buying long, but with an important difference - short sellers must pay interest on borrowed shares.
Critical Thinking
- If you plan to invest your money for retirement, which investment strategy is best - buying long or selling short?
- Are short sellers more likely to be long-term investors or short-term traders?
- Why do short sellers exist in the marketplace? Do they serve an important function?
- Often, when a stock on the decline has been sold short in large quantities, short sellers must eventually buy to cover so they can cash in on their profits and stop paying interest. What will happen to the share price if all of these short sellers buy to cover at the same time?
- At least in theory, stock prices can go up forever, but can only drop to zero. What is the short seller's maximum profit opportunity?
