In this article, we’re gonna talk about what it means to sell a stock short. So typically we think of making money in the stock market by buying a stock and waiting for the price to go up so we can realize a return but we can also make money if the price declines and we do that through a short sale. This is basically a process of borrowing shares from a broker and then we take those shares that we borrowed and we immediately sell them on the market and then we wait for the price to drop to go down. That’s a key assumption here we’re betting against the stock we think that the price is going to go down and that benefits us, because then once the price does go down then we can purchase the shares for that lower price and then give them back to whoever it was that lent us the shares, to begin with.
Let’s say that you’re looking at selling short Microsoft so MSFT that’s the ticker symbol for Microsoft. Let’s say that the stock price is currently trading at $32 a share and so you think that the price of Microsoft is going to go down. Now there could be any number of reasons that you believe that let just says that you think that cloud computing is just going to devastate Microsoft’s business model and that they’re just gonna have all kinds of problems and that their business is just gonna fall apart the stock price is going to go down. So you call a broker to let’s say you call “Lucy” the broker here and you say “I want to short 1,000 shares that just slang for saying you want to sell short a thousand shares.
So Lucy is a broker so Lucy has a brokerage account and there’s let’s just say that this circle here this is Lucy’s brokerage account and that represents a pool of securities that Lucy is managing for different investors and let’s say that there’s an investor named “Mariya” that owns this sliver here let’s say this is Microsoft shares that are owned by Mariya.
Mariya institutional investor who owns a thousand shares of Microsoft or could be more than a thousand shares and in any case, Lucy is the broker who is managing those shares and you come in and say “Hey Lucy what I would like to do is I would like to short a thousand shares” So basically Lucy will say “Hey great, Mariya has a thousand shares of Microsoft just sitting here, I will give them to you. So I will give you one thousand shares of Mariya’s Microsoft stock” and you might say “Hey isn’t Mariya gonna have problem with this?” Well Mariya might not even know that this is happening, right? Mariya doesn’t need these shares right now they’re just sitting in the brokerage account.
So Lucy lends you the 1000 shares of Microsoft stock and what do you do? You turn around and you immediately sell the shares. So what are you gonna recognize on that? You’ve got 1000 shares multiplied by $32 a share. Where did I get the $32 from? Well, that’s the current stock price right you think the stock price is gonna go down. You think it’s gonna go to less than $32. So you borrow these thousand shares and you say “I’m gonna sell it right now” and so you get $32000, right?
So you’ve sold the shares now what happens is you play a waiting game and ideally, the stock price of Microsoft is gonna go down otherwise you’re actually going to incur a loss which we’ll talk about later. Let’s assume the three months go by and Microsoft makes some kind of announcement and says “You know what actually cloud computing, we just don’t know that we can compete and we’re having all these problems” and so their price does go down. So their price goes down to $27 a share. So now things are working out for you the price dropped like you thought. So what do you do you buy 1000 shares. So you buy these thousand shares at $27 a share so that’s 1000 shares times $27, so that’s gonna be 27,000 that you’re paying for these shares.
Now what you’re gonna do is you’re gonna give these shares back to Lucy and Lucy’s gonna put them back in Mariya’s account. So all that happened is is you borrowed these thousand shares upfront and then now that you buy them you’re actually returning them. So you’re returning them back to Mariya’s account that Lucy is managing for Mariya. You borrow the thousand but now you have to put them back but the thing is you might want to know where you make money on this?
Well look when you originally sold them for 32,000 but now you waited the price went down and you bought them back for 27,000 so even though you’re returning shares, the same amount of shares, actually it was cheaper for you to buy them than what you originally sold them for.
So now you’re gonna have some other costs here let me just show you. So we can think about this is you’re realizing a gain. You’re gonna have 32,000 that’s from when you sold the shares and then you bought them back at 27,000 so you’ve got this $5,000 gain.
Now of course it’s gonna be a little less than $5000 and here’s why. You have to pay Lucy a fee, right? Lucy isn’t going to do this for you for free. So that she’s running this transaction for you. Now you have to reimburse Mariya. She doesn’t get any of your $5,000 gains in the sense that Mariya is benefiting from the short sale but you reimburse Mariya if there are dividends.
So think about it like this, it was three months went by before the price dropped and you bought the shares back, right? So that was three months that you waited for the price to drop, well Microsoft might have issued dividends during that time, and because technically the shares have been sold and you haven’t bought them back yet and they’re kind of they’re not in that Mariya’s account even though Mariya were to look up online and see what was in her account she would see that but technically the shares don’t exist in there at that point of time and they’re not giving any dividends so you need to reimburse Mariya for any dividends that were lost that’s gonna come out of your $5,000 gain.
So I should just say here $5,000 our gain – ( Fee for Lucy + Dividends for Mariya) but you can see there’s quite a lot of money that’s to be made here. Now, remember you made a big bet here. You made a big bet that the price was going to drop and it did drop so you made money but the price could have gone up even if you’re right about thinking that the road cloud computing is gonna cause these problems from Microsoft the timing of your short sale might be such that maybe you say that you’re gonna sell the stock short and then Microsoft has some kind of positive unexpected earnings announcement or they sign some contract with some customer they do something and the stock price goes up in the short term and then now you’ve got a problem because the stock price just went up and now if instead of being able to buy the shares at $27 a share let’s say you had to buy them at $40 this year.
So now there’d be $32,000 minus $40,000 now you’d have an $8,000 loss. So you’d lose $8,000 if the price went up to $40 to share and you still have to pay the fee and so forth and reimburse Mariya for any dividends and so on. Also bear in mind, Mariya might have wanted his shares at some point in time. You might say well “Hey if the three months go by and the price has gone up I’ll just do nothing I’ll just wait five years I’m not gonna do anything” but Mariya might say “You know what I would like those shares back” in which case I mean if it happens like a day later where she’s like I want the shares back maybe Lucy the broker has some other shares of Microsoft from somebody else some other investor that he could give you and then give the shares to Mariya but if it’s something where it’s just taking a long time and Mariya needs the shares or maybe Lucy doesn’t have other shares to give Mariya, Lucy could actually force you to close out the position so you might have to close out the position.
Mariya wants the shares back or if Lucy just thinks “You know what the price has gone up a lot I’m worried that you’re not going to be able to cover this position and I’m just going to force you to close out the position and just take the law”.