Thread on Short Selling.
Short selling is what investors do when they want to bet against a stock.
It’s the opposite of a long position (where they bet the value of the stock to go up over time).
So how do you make money on a failing company?
Take this fictitious example:
Short selling is what investors do when they want to bet against a stock.
It’s the opposite of a long position (where they bet the value of the stock to go up over time).
So how do you make money on a failing company?
Take this fictitious example:
Shadow thinks the value of drug company ShadowPharma is overinflated, and that it will soon report that it's trials for its new drug were a failure.
Shadow approaches institutional investor Shadow Capital, which owns ShadowPharma stock to borrow 1 million of their shares.
Shadow approaches institutional investor Shadow Capital, which owns ShadowPharma stock to borrow 1 million of their shares.
Shadow Capital agrees, and charges Shadow a monthly fee of $5 million until he returns the shares.
Shadow takes ShadowPharma's shares and immediately sells them for the going rate of $100 each, depositing $100 million in his account.
Shadow takes ShadowPharma's shares and immediately sells them for the going rate of $100 each, depositing $100 million in his account.
But remember, he still has to return 1 million shares back to Shadow Capital. If Shadow is correct, then scenario A plays out:
Within 30 days, ShadowPharma announces the drug trial failure, and its stock falls to $20 per share.
Within 30 days, ShadowPharma announces the drug trial failure, and its stock falls to $20 per share.
Shadow repurchases 1 million shares for $20 million, and returns them to Shadow Capital, minus the fees he owes, and makes just under $80 million.
Now don't get excited, it's not always rainbows.
Here's the huge risk:
Now don't get excited, it's not always rainbows.
Here's the huge risk:
Scenario B:
Shadow's hunch was wrong and ShadowPharma announces that its world-changing productivity drug is a success. Its stock price immediately skyrockets to $300 per share.
Shadow's hunch was wrong and ShadowPharma announces that its world-changing productivity drug is a success. Its stock price immediately skyrockets to $300 per share.
Shadow now has two pretty terrible options:
Buy the shares at the new price and take a $200 million loss, or wait it out, hoping the price comes down to a level he can stomach, during which time she’s still paying Shadow Capital $5 million per month.
Ouch.
Buy the shares at the new price and take a $200 million loss, or wait it out, hoping the price comes down to a level he can stomach, during which time she’s still paying Shadow Capital $5 million per month.
Ouch.
It’s for this reason that only very experienced and very liquid investors should be taking short positions.
If you’re long on a stock that you purchased for $100 per share, you can only lose $100 per share.
But if you short that stock, your losses can be life-changing.
If you’re long on a stock that you purchased for $100 per share, you can only lose $100 per share.
But if you short that stock, your losses can be life-changing.
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