Selling Yourself Short

Article excerpt

IN REACTION to the collapse of Lehman Brothers, governments around the world moved to ban the short selling of financial industry stocks. Short selling is a strategy employed by investors who believe a stock or other financial instrument will soon fall in price. Politicians and regulators feared that short sellers would drive down the stock price of financial firms, worsening their already weak condition. However, short sellers and other market participants were expressing their judgment regarding the health of these companies--a judgment that governments wished to suppress. Rather than listening to what the markets were saying, governments tried, ultimately without success, to present an alternate reality.

So, what is it, exactly, to short a stock? To answer this, let us first consider its opposite, taking a "long" position. Let us say stock in Apple Inc. is Wading for about $250 a share on the New York Stock Exchange. If my bank is willing to lend me $1,000 for the next 12 months, and I take an optimistic view of Apple's prospects, I can borrow the money and use it to buy four shares of the stock. In market jargon, this borrow-and-buy strategy is known as taking a long position. Then, if my optimism turns out to be justified and the price a year from now is, say, $300 per share, I will be able to sell my four shares for $1,200, giving me a 20% return (less interest on the bank loan and any brokerage fees, bid-ask spread, etc.). Another way of thinking of this process is that it involves buying an asset denominated in a currency (Apple stock) that appreciated in value over the year.

Now suppose that, instead of being a bull, I take a bearish view of Apple, and expect the price to fall by 20% to only $200. How can I trade on my prediction? If my outlook is bearish, I ought to create a position that will rise in value when the share price falls--in other words a negative asset, a liability denominated in Apple stock. This can be achieved straightforwardly by borrowing the shares from a holder of the stock who is willing to lend them (usually via a broker) in return for a small fee. Ignoring transaction costs, the lender's fee, and any interest costs, the arithmetic is as follows. I borrow four shares now and sell them immediately for $250 a share, bringing me a cash inflow of $1,000. At the end of the year, I go back into the market to buy four shares in order to pay off my lender; if my forecast is right, I will only have to pay $200 for each share. That would leave me with a profit of $200, or 20%.

The symmetry between short sales and purchases is not complete, however, because of the difference in risk profile. On the one hand, if I am wrongly bullish about Apple, I could lose the whole of my investment--all of the $1,000--if Apple goes bankrupt and the stock becomes worthless, but, on the other hand, the maximum possible loss on a short sale is unlimited, because if my bearishness proves unfounded and the stock price rises, I lose $1 for every $1 rise in the price, multiplied by the number of shares that I shorted. Since the upside is, at least in theory, unlimited, so is my potential loss. Short selling therefore is inherently riskier than buying stock. …