Short Sale -- How It Works

[Skotty]

So I had a sort of specific question, but maybe I should open this up to a general discussion of how a short sale works. It's a little confusing to folks who are not deeply into markets.

The idea is kind of a reverse investment, where you "sell" your stock for the market price without having actually bought any yet. Later, you are obligated to buy the stock you "sold".

Honestly, I thought about it briefly, but I will have to think about it much harder, as I can't quickly identify the most likely scenario of how this works. Where does the money come from? Is stock actually purchased? Who holds the stock?

Regardless, here's my original question that initially prompted me to make this thread. How long does a short seller have before they have to buy the stock? Does it vary from agreement to agreement? There has to be a limit though -- otherwise, the short seller could just wait forever and never be at a loss.

 

[JohnSnowNW]

I found this to be a helpful explanation:

Options Basics: What Are Options? | Investopedia

 

[MSullivan]

So I had a sort of specific question, but maybe I should open this up to a general discussion of how a short sale works. It's a little confusing to folks who are not deeply into markets.

The idea is kind of a reverse investment, where you "sell" your stock for the market price without having actually bought any yet. Later, you are obligated to buy the stock you "sold".

Honestly, I thought about it briefly, but I will have to think about it much harder, as I can't quickly identify the most likely scenario of how this works. Where does the money come from? Is stock actually purchased? Who holds the stock?

Regardless, here's my original question that initially prompted me to make this thread. How long does a short seller have before they have to buy the stock? Does it vary from agreement to agreement? There has to be a limit though -- otherwise, the short seller could just wait forever and never be at a loss.

Imagine a gallon of gasoline and a tank. Let's say gas is $4 a gallon and you think it will go down. You sell 10 gallons of gas from your neighbor's tank (he is out of the country and won't need it anytime soon) for $40 to some person. Now a month later, your friend is still out of the country, you go down and buy 10 gallons of gas for $30. You put it in your neighbors tank and pocket the $10.
Now if gas goes up to $5 a gallon you lose $10.
Now imagine instead of one neighbor it is an airport parking lot. If the guy you got the gas from is coming back tomorrow (wants to sell the stock you borrowed) you just siphon 10 gallons from the guy that just parked and won't be back for two months.
The parking lot is your brokerage firm and they move the gas around for you.
There is one big downside, the most a gallon of gas could go down is $4. There is no limit to how high it can go. And if it goes to high your broker may make you cover it. That is why stocks surge sometimes. People short Tesla, they have great earnings, it goes up a lot. Then short sellers get calls to cover and they panic and it goes even higher.
Hope that makes sense.

 

[neroden]

In order to sell the shares without owning them, the short seller borrows stock from the brokerage (for instance, from Schwab). The brokerage borrows the stock from one of the brokerage's other clients.

Here's the bit you might not know: Brokerage clients who use margin borrowing sign a contract which allows the brokerage to borrow their stocks for free. If you have no margin loans outstanding, the brokerage can't borrow your stock, but if you do have margin loans outstanding, they can borrow it.

This is how the brokerage can lend the stock to the short seller for free without charging interest.

If there aren't enough clients with margin loans holding the stock -- lets use SCTY as an example -- so that short sellers want to borrow 2 million shares of SCTY, but there are only a million shares in accounts of clients with margin loans -- then the brokerage will ask other clients who aren't using margin to lend out their shares of SCTY, and the brokerage will *pay interest* to those holders of SCTY. The short sellers will then be *charged interest* for borrowing the SCTY shares.

 

[kelly]

Imagine a gallon of gasoline and a tank. Let's say gas is $4 a gallon and you think it will go down. You sell 10 gallons of gas from your neighbor's tank (he is out of the country and won't need it anytime soon) for $40 to some person. Now a month later, your friend is still out of the country, you go down and buy 10 gallons of gas for $30. You put it in your neighbors tank and pocket the $10.
Now if gas goes up to $5 a gallon you lose $10.
Now imagine instead of one neighbor it is an airport parking lot. If the guy you got the gas from is coming back tomorrow (wants to sell the stock you borrowed) you just siphon 10 gallons from the guy that just parked and won't be back for two months.
The parking lot is your brokerage firm and they move the gas around for you.
There is one big downside, the most a gallon of gas could go down is $4. There is no limit to how high it can go. And if it goes to high your broker may make you cover it. That is why stocks surge sometimes. People short Tesla, they have great earnings, it goes up a lot. Then short sellers get calls to cover and they panic and it goes even higher.
Hope that makes sense.

Thank you for that very understandable explanation. If the shorts "get calls to cover," and they have to buy the stock at a higher price, what affect does that have on the overall price? In the short term stock thread I see people talking about battles between shorts and longs at any given time during the day keeping the stock at a certain price, and I don't really understand what they mean.

 

[MSullivan]

One person buying a stock doesn't do much to the price. Thousands do, especially when there aren't as many sellers. They have to keep raising their offers till they get takers.

 

[cwerdna]

Imagine a gallon of gasoline and a tank. Let's say gas is $4 a gallon and you think it will go down. You sell 10 gallons of gas from your neighbor's tank (he is out of the country and won't need it anytime soon) for $40 to some person. Now a month later, your friend is still out of the country, you go down and buy 10 gallons of gas for $30. You put it in your neighbors tank and pocket the $10.
Now if gas goes up to $5 a gallon you lose $10.
Now imagine instead of one neighbor it is an airport parking lot. If the guy you got the gas from is coming back tomorrow (wants to sell the stock you borrowed) you just siphon 10 gallons from the guy that just parked and won't be back for two months.
The parking lot is your brokerage firm and they move the gas around for you.
There is one big downside, the most a gallon of gas could go down is $4. There is no limit to how high it can go. And if it goes to high your broker may make you cover it. That is why stocks surge sometimes. People short Tesla, they have great earnings, it goes up a lot. Then short sellers get calls to cover and they panic and it goes even higher.
Hope that makes sense.

Good analogies. Also, Short Squeeze Definition | Investopedia might helpful.

Another way to look at it. When people buy stocks, they're long. They buy at a given price and hope that it goes up so that they have a profit. The max loss is the price they paid for the stock. The max gain is potentially infinite.

When one short, the max gain is the price of the stock when they opened the short position. Example: If they short some stock at $200, the max gain is $200, which would happen if the stock became $0.

The max loss is potentially infinite. Imagine the pain that one could feel if you had short position of 100 shares at $1 and the short seller didn't want to close thinking it will come back down and the stock ends up hitting $1000? He pocketed $100 to open the position but will need to pay $100,000 to close it out, meaning a loss of $99,900, not including any margin interest.

It's even worse if it's a dividend paying stock. You'll need to pay the dividend.

Regardless, here's my original question that initially prompted me to make this thread. How long does a short seller have before they have to buy the stock? Does it vary from agreement to agreement? There has to be a limit though -- otherwise, the short seller could just wait forever and never be at a loss.

No. There's no time limit. Short Selling: A Trader's Guide may help.

I found this to be a helpful explanation:

Options Basics: What Are Options? | Investopedia

Not sure why you'd bring this up. I dabble w/options myself but I'm an amateur. One can make any number of plays re: a stock (bullish, bearish, neutral, etc.) via options often spending far less capital than buying/selling the underlying stock.

OP is strictly asking about shorting stocks, not derivatives (e.g. options): borrowing a stock and selling it, hoping that he can close it out at a profit when the stock drops below the price that the short position was opened.

A simple bearish play would be to buy puts. Another way would be to buy put spreads.

 

[GoTslaGo]

@Skotty, I thought you were talking about houses at first!

Good thread and great responses. I had the same questions!

 

[JohnSnowNW]

Not sure why you'd bring this up. I dabble w/options myself but I'm an amateur. One can make any number of plays re: a stock (bullish, bearish, neutral, etc.) via options often spending far less capital than buying/selling the underlying stock.

It's a good basis for understanding it, and has embedded links to more information specifically about shorting.