A Super Simple Explanation of What Short Selling is

This is going to be the simplest explanation of “What is Short Selling” that I can make. I am not doing this to ridicule viewers, but because this article is targetted at people with 0 knowledge of finance whatsoever.

So first, we need to define a company. For the purpose of this text, a company will be defined as an entity which provides a good and/or a service to people. Google’s gives people a search engines, phone, etc. McDonald’s gives people burgers, fries, etc., you get it. There are companies that don’t deliver anything to people (such as fiduciaries or tax loopholes), but let’s forget about them for now.

Companies belong to someone, something or a group of someone. A company can be private. You could go out tomorrow and start a company and it would be 100% yours. But let’s say you needed money to start your company. You need to buy a factory, build a store, buy inventory, pay marketing, etc. What do you do?

You have two major options (again, there are exceptions here, but they’re irrelevant for now)

  • DEBT: You borrow money from someone. A bank, a millionaire, etc.
  • EQUITY: You give control of a percentage of your company to someone, in exchange for money.

It’s obviously a bit more complex than (you could pay royalties, percentage of your sales, etc.) but overall let’s keep it at that.

EQUITY means stocks. If you have shares of a company, then you own a percentage of this company. If you have 100 shares of Apple and Apple has 100,000,000, shares, then you own 0.00001% of Apple. If you own 50,000,000 of Apple, you own 50% of Apple.

Simple enough?

To give you an example, Mark Zuckerberg owns 28.2% of Facebook. Bill Gates owns 4% of Microsoft.

That owernship can be sold at any time. Mark Zuckerberg could decide tomorrow morning, “You know what guys, I don’t want to own Facebook anymore. I’m going to sell my shares.” Of course, it’s not entirely as simple and he would face severe limits (people would flip out if the saw the CEO was dumping his shares because they’d think the company is crashing. There are also laws saying how much he can and cannot sell, and when), but that’s basically how it is.

Okay, so let’s take Apple shares, which trade on the NASDAQ, an exchange. NASDAQ can be compared to a giant server room. It allows buyers and sellers to, well, buy and sell shares. And it’s monitored to make sure no funny business – or mistakes – happen. Fun fact: Facebook had huge problems at IPO and NASDAQ had to pay and compensate some people.

So let’s go back to Apple. Let’s say you think Apple is going very well and is going to keep going very well. What do you do? Well, you buy shares. If the shares go up, you win money. After all, remember: you own a percentage of the company and if the company gains in value, the shares should too, and they should go up. Some fancy stuff happens from time to time, but that’s finance 101 here.

Say you buy 100 shares of Apple (NASDAQ:AAPL) at $100. A month later, the stock is worth $120. You sell your stocks, earning 100 x ($120-$100)=$2,000. Congratulations, you just made a $2,000 profit from clicking two buttons.

But what if you thought Apple would go down?

Why would you think that? Well, let’s say you believe Apple is overpriced. Let’s say you think Apple is going to go down. You believe it will sell less iPhones and make less money. What do you do then? If you had shares, you could certainly sell them, but you don’t have any. So what can you do?

You can “short sell” shares.

Here’s how it goes: you want to short sell AAPL shares. You find someone who has AAPL shares and you “borrow” them from him. Then, you sell them.

Still with me?

First, let’s introduce what a broker is. A broker does trades for you. It buys and sells shares for you. If you tell your broker to buy 100 shares of Apple, it will do so and hold them in your name. When you buy stocks through a broker, the stocks are not truly yours (they do not have your name on them), but your broker associates them with your account and only you can decide what to do with them. You can use them to vote at general assemblies, etc.

Could you buy the stock directly yourself? Absolutely, but it would usually require you to have access to the exchange which is, well, super costly and has TONS of legal requirements. So forget it. Again, there are exceptions, but this covers 95% of it. Robinhood is a broker, as is Questrade, Interactive Brokers, eTrade and many, many others.

Yes, you can literally take someone’s shares and sell them. This actually causes a few problems, as we’ll see a bit later, but this is how short selling works. To short sell a stock, you NEED to borrow them from someone, you just cannot invent shares from thin air. You used to be able to do that and in fact you might get away with it once in a blue moon (it’s called naked short selling and if your broker is caught doing that too often, they are fined), but the very basic point is: you NEED to borrow someone’s share.

How?

Before we go further, we need to introduce the types of accounts you can have with a broker. Remember those guys from earlier? Legally, there are two accounts you can have: cash or margin. First, a cash account means you need to pay 100% of your trade in cash. If you want to buy 100 shares of AAPL and each share of AAPL is $100, you need 100 x $100 = $10,000 in your account. Plus commissions. No exceptions. If you have $9,999 in your account, you can’t buy 100 shares of Apple.

Cash accounts are typically used for new investors, small value accounts or tax-exempt accounts (401k, etc.). Some tax exempt accounts by law must be cash account.

Second, a margin account allows you to borrow money to do your trades. If you want to buy 100 shares of Apple and Apple trades at $100, you only need a fraction of the $10,000 in your account. For my broker, this amount is typically 30%, so if I wanted to buy 100 shares of Apple, I would only need 30%*$10,000=$3,000 in my account. Of course, I am still buying those shares and I would need to pay the seller the entire amount. The broker would simple debit me.

In other words, if I had $3,000 in my account and wanted to buy 100 shares of AAPL ($10,000 value), I would end up with -$7,000 in my account. The broker would then charge me interest, daily, on that $7,000.

Okay. So whenever you buy shares in a cash account, they become unshortable. Nobody in the world can borrow them forcefully from you, not even if you wanted to. But when you buy shares in a portfolio account, anyone can short sell them at any time. This means if I have a portfolio account and bought 100 shares of Apple, anybody could “force borrow them” and short sell them at any time WITHOUT EVEN TELLING ME.

WHAT?

Yes, this is correct. If you hold shares in a portfolio at any time, they can be shorted at any time. They do not need your consent. Well, technically, when you signup for a broker, it’s somewhere in the documentation. There are ways to prevent your shares from being shorted, but it’s out of the scope of this article.

For instance, right now, I have a portfolio account and I have shares of Canadian Imperial Bank of Commerce that are being shorted by someone. Yes, you can know when your shares are being shorted (sometimes). There’s nothing I can do about it.

But this isn’t fair!

No it isn’t, but that’s how it is.

Brokers love to do that because brokers typically charge a fee to people for shorting. So if someone short sells my shares, he has to pay interest to my broker daily. That’s how brokers make their money.

Okay, so let’s say I want to short sell something, what happens?

So to go back, you think Apple is going down and you want to short sell it. I should note short selling is pretty much automatic. Your broker will usually find someone who has shares of the company you want to short for you. Remember: how they make their money.

So to short sell, I just give the order: “SELL 100 AAPL @ $100.” The broker goes through his database, finds a sucker with AAPL shares, “borrows” the shares from him and sells them.

That’s it.

That’s it?

Yes. It’s really that simple. I end up with -100 shares in my account. Yep, a negative number.

Now, let’s see what happens. Let’s say AAPL goes down to $80. I want to cover my shares. I just “buy” 100 AAPL shares and give them back to the guy I borrowed from.

My total profit: 100 * ($100 – $80)= $2,000.

So I just made a $2,000 profit from Apple falling from $100 to $80.

What’s the catch?

There are none. That’s basically short selling 101.

It should be noted that at the moment I short sell, I receive the cash. So when I click “SELL 100 AAPL @ $100,” $10,000 are deposited in my account. I can take that money and party if I want to. Or, you know, invest it in something else. Maybe even invest it in Samsung.

Okay, but what’s the issue with short selling then?

There are a few things. Let’s say I have a lot of money and I want to crash a stock. There is nothing preventing me from massively short selling a stock until it crashes. This, in fact, happened quite a bit during financial crisis and my belief is that it happens more often than we like to admit.

Say for instance I short sell enough AAPL @ $100. The prices drops to $95. People panic and think something big is going on. The price keeps dropping as people hit their stop losses and the stock crashes to $90. I then cover my short by rebuying at $90. I have made $100-$90=$10 instantly.

During the financial crisis, this kind of situation was supposedly common and some rules were introduced to ban short selling on some stocks. There was the uptick rule, for instant, which said that if a stock fell more than 10%, it couldn’t be shorted again until it went up. Opinions diverge on whether short selling can effectively crash a company’s stock. My personal belief is that it does.

That’s it?

Another massive problem happens when a company pays a dividend. Let’s take AAPL again. You own 100 shares of AAPL, but someone short sold them. AAPL is about to announce a $0.52 dividend. You thus expect to receive 100 x $0.52. Only problem is, you do not own the stock anymore! Someone sold it!

What happens then? Well, legally, the person who short sold the stock is forced to cover the dividend, i.e. to pay you $52.

So there’s no problem?

Yes there is, because the $52 is not considered an eligible dividend and, in most cases, won’t be eligible for the reduced tax rate. You will be taxed in full on that $52.

Uh-oh.

Some broker will cover the difference, so if the dividend is $52 and you are forced to pay 10% more taxes, they will force the short seller to pay you $57.20. But not all brokers.

And there’s nothing I can do about it?

Aside from holding your stocks in a cash account, no. I lose a couple of hundreds at tax time myself due to short sellers.

A notorious short seller is Andrew Left who almost exclusively short sells companies, often crashing as soon as he releases his report. See: Valeant.

Why is that legal? The stock market should exist to create wealth, not purposely hope a company is going to go down!

Short selling has more applications than just speculation (i.e. betting the stock will go donw). It has applications for risk management. Furthermore, short selling supposedly allows for a fair, balanced and honest stock market.

But wait a minute… If I own shares of AAPL and someone short sells them, then he is hoping the shares goes down! He is my nemesis!

Precisely. For every dollar you make, he is going to lose one, and vice versa.

There’s a lot more to short selling (short interest, days to cover, short squeeze, margin requirements, etc.) but for this lesson, we are going to stop here. Hope you understand what short selling is a little bit better now.

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