Today we will look at 2 ways to profit from movement in the market – one by being “long” an asset and profiting when it increases in value, and another by “shorting” an asset and profiting when it loses value. What do these terms mean and how do you accomplish these objectives? Here is the long and short of it all…
When someone says they are “long SBUX” or “long BRK.B” what does that mean? Basically it means that person owns the stock and will benefit from seeing the security increase in value. In most cases it indicates an investment horizon measured in years or even decades, but a person could be long SBUX and sell it 24 hours later if it reaches his price target in a short amount of time. Going long is really not an indication of a timeframe, but an indication of ownership. Simply put, being “long” means you own the stock, the bond, or the commodity and you expect to see the price of the asset increase in value over time.
Amazon is an example of a very good long position @ +1,000% over the last decade…
Your upside on an asset in which you are long is infinite. If a stock you own continues to rise and rise and rise, you will continue to show an increasing “unrealized gain” until the point at which you sell and capture your “net gain” which equals the price at which you sell, minus the price you paid, minus trading commissions, and plus any dividends earned along the way. There is theoretically no cap on the money you can make.
Your downside, however, is capped at 100% of your investment. If you buy a stock for $10/share and it goes to zero you’ve lost 100% of your original investment, plus the commission you paid to buy the stock. You cannot lose more money than you paid for it.
When someone shorts a stock it is a different story all together. When you short a stock you are doing so because you feel the price of the stock will decrease in value. This will require you to sell a stock you do not own (a short sale). How in the heck do you do that?
Amazon versus Snapchat – SNAP would be a bad long, but a profitable short.
Let’s look at Snapchat (SNAP) and say you want to short the stock when it sits at $20/share because you think it’s worthless crap. When you short the stock you borrow someone else’s share via your brokerage and you sell it on the open market for $20, depositing that cash into your trading account and providing the lender an IOU for a share of SNAP that you will return to him sometime down the road. When the stock hits, say, $5/share, you can buy a share on the open market for 5 bucks and give that share back to the lender, closing the deal and leaving you with a $15 profit. Boom! The stock lost $15 and you made $15, minus costs and commissions which we will look at below. This is called “covering your short” at which point you have exited the trade, and in this case exited a winner.
Some Caveats on Shorting:
Caveat number one – in order to short a stock you must have a margin account which means your broker must have the ability to loan you money to trade with since you are selling a stock you do not own, but you are borrowing. You must have 1.5 times the amount you are short on margin, meaning if you borrow a share of SNAP at $20, you must have $30 on margin in your account.
Why? When you sell short, the borrowed share represents debt/liability and thus represents risk. If SNAP moves against you and jumps from $20 to $40 you will now owe more money than you received in the short sale and it’s possible you may not be in the financial position to return the share. You’d have to buy a share at $40 to return to the lender, but you only have $20 in your account from the short sale, so you’ll have to chip in another $20 from somewhere else to exit the trade. This is why you have the $30 on margin and the broker will use your margin as collateral to back your position in an effort to ensure the shares are returned.
A margin account also allows your broker the ability to liquidate your position himself if he determines you have reached a point where you will not be able to return the borrowed share. This is known as a “margin call” and it essentially means you may be up a certain creek without a certain hand-held device. Under Regulation T of the Federal Reserve Board, these margin agreements are required for any short selling. Furthermore, you cannot short stocks in tax-sheltered accounts like 401Ks, Roths, or IRAs under this same regulation.
Caveat number two – in order to short a stock you will have to pay a stock loan fee (borrow fee) and that fee will vary depending on how hard the stock is to borrow. If a large percentage of traders thinks SNAP is a dog, then your borrow fee is going to be higher than a stock like AMZN.
You will also be responsible for paying any dividends a stock earns while you are short the stock, as dividends are paid to the owner of stock and not the short seller. The longer it takes for you to buy the stock on the cheap and return the borrowed share, the higher these costs will be and they will chip away at your potential profit over time. (By the way, SNAP does not pay a dividend, just to be clear.)
Your upside on a short sale is limited to the amount of your short sale and nothing more, meaning if you short SNAP at $20 and it goes to $0 then you make $20 minus your borrow fees and commissions, since the borrower is not going to ask for a share worth $0 to be returned. This is your absolute best case scenario when shorting a stock.
Your downside, however, is not capped per se. If Snapchat is bought out by the Kardashian family, catches fire, and stock price goes to $1,000 when you are short $20, you will be on the hook for another $980 to buy a share @ $1,000 to return to your lender, and the percentage figure of your loss would have a comma in it… Obviously the broker’s margin account is designed to shut you out before this happens, as explained above, but you can see the downside risk when shorting is much higher than when you are long the stock and capped at a max 100% loss if the stock tanks.
A quick story about short selling – in 2015 an investor named Joe Campbell shorted $37,000 worth of KaloBios Pharmaceuticals only to find out a few hours later that the shares of the company rapidly skyrocketed 800% when Martin Shkreli, CEO of Turing Pharmaceuticals, gained control of a majority KaloBios’ outstanding shares. Campbell’s broker was unable to react quickly enough to close out his position and after the dust settled Campbell found himself $106,000 in debt. He was forced to cash out both his and his wife’s 401(k) plans to cover his short position and buy/return the borrowed shares to exit the trade. He started a GoFundMe page to request financial assistance after the debacle, but it was a train wreck there and he received very little sympathy, raising only $5,000. That is an example of the unlimited downside when shorting a stock.
To wrap up short-selling – don’t do it. Concentrate your investing in tax-advantaged accounts to the fullest extent possible. Maybe you get to the point where you are 100% comfortable with the terms, the procedure, the techniques, the risk, the requirements, and the timing of short selling. Even then, take a breath, go for a walk, sleep on it for a week, and then dedicate very small percentages of capital toward short selling if you decide you absolutely must take it on…
You have probably heard of a “hedge fund”. A hedge fund uses short positions to “hedge” its long positions both for safety and to increase returns. The simplest hedge is to go long (buy) a selection of stocks in the S&P500 that you think will outperform the S&P500 as a whole, and then short the S&P500 itself in equal proportion. If you think Amazon, Facebook, and Google will outperform the S&P500 you could go long those 3 stocks and then short an equal value amount of SPY (the S&P500). This hedge would would essentially eliminate any profit & losses resulting from stock market fluctuations, and the return on your investment will be dependent upon the performance of Amazon, Facebook, and Google relative to the S&P500 as a whole.
For most investors, I do not recommend this – but this is how it works so I thought it was worth mentioning. There are other forms of hedging that get much more complicated, but you get the point… I may write more about hedge funds later as they are all the talk, all the rage, but do they live up to their hype? And how can you / should you invest in a hedge fund?
Options & Derivatives:
There are creative ways to go long a stock and to short a stock using options & derivatives as well. I am not going to go into them here because for a vast majority of investors the will be too risky and too hard to maneuver effectively. Stay away. Warren Buffet calls derivatives “financial weapons of mass destruction” and I would equate the options market to playing poker while simultaneously taking a master-class in Calculus.
Alright then – this is just a quick little primer on how some basic investing principles work and what some of the terminology means. To be honest, this is a bit of a “do is I say, not do as I do” lesson – The Man on the Move does short some stocks and uses options from time to time, and he is currently invested in derivatives as well. Hey – I also love a good poker game, betting on horses, and I rarely watch a sporting event without a little action on the side. I’ve been known to bet on 2 cats crossing the road and once had a wager in a real-life pissing contest. I like action…
In the end, your comfort level and your record of success can guide you and develop your investing style, but listen – there is absolutely nothing wrong with investing in a simple (some may say boring) indexing strategy and letting the headlines of massive gains and losses from short selling, trading options, and nuking derivatives just pass you on by…