What do you mean Short Sell a stock?

What is a Short Sale anyway?

09.16.11 Posted in Economics by

This post isn’t about the real estate variety of short selling (you know, the kind you’d expect me to talk about…). If you want to know what a short sale is in the real estate world check out my post, “What is a Short Sale anyway?“. Hey… that sounds familiar.

I’m talking about short selling stocks. And nope, I’m not an expert; but this is my blog and I’ll talk about it if I want to.

Economics and Finance 101

We’re all familiar with short selling’s better known sibling: “going long”. That’s to say, an investor buys a stock in Company A and hopes that, for a variety of reasons, that stock goes up thereby making a profit after selling the stock at the higher price.

In fact, the majority of all trading is done in this manner. And one of the reasons its called going long is because investors tend to hold on to their investments over long periods of time thus mitigating much of the risk of the stock going down and losing money on the investment.

Frankly its pretty boring stuff.

Come on! Get to it!

Fuji ApplesSo what does it mean to short sell a stock? The idea is really simple actually.

Lets say you are a young entrepreneur down at the farmers market sipping your cup of coffe. Across the street is an apple stand in the market. They are selling your favoriate variety of apple (the Fuji apple: crazy delicious) for $1/ apple. However, you’re pretty confident these apple’s are being sold at a premium currently and chances are the vendor will be selling them for $0.50/ apple by the end of the day. (Don’t ask questions! Just go with it.)

So what do you do?

Well, you certianly don’t go buy the apples, right? In other words, you’re not going to go long.

What you ARE going to do though is ask the vendor to borrow 10 apples. Since the vendor is drunk a great guy he gladly LOANS you the 10 Apples and you promise to deliver them back near the end of the day.

So, Short Selling is like borrowing Apples?

Sort of. But you are borrowing stocks from a brokerage of a company. Got it?

Great, so you head to the other end of the Farmers Market and quickly sell those apples for $1 / apple for a total of $10.

AWESOME! You’ve got $10! But you don’t have the apple’s you’ve just borrowed. And that’s a problem because that apple vendor wants his apple’s back at the end of the day.

So instead of panicking and trying to make it to Mexico with your $10 you go back and finish your coffee. And you wait. What are you waiting for? The price of apple’s to come down.

Risky Business

And that’s the rub. You’ve sold a borrowed asset (10 apples in this case) and at some point you have to BUY BACK 10 APPLES to deliver back to the drunk really nice apple vendor.

If the price of apples goes up to $1.50/ apple when you buy them back then you’ve just lost $5. If the price of the apples goes down to $0.50/ apple then you’ve just pocketed $5. Obviously the hope is you’ll make money and not lose money.

See, its so simple when explained so eloquently!

I ❤ apples.

So now we know why people short sell. They want to make money. But like with any analogy it doesn’t tell the whole story. The Securities and Exchange Commission actually banned short selling of certain stocks in 2008. And I’m pretty sure I’ve heard they’ve taken similar steps more recently too.


Because short selling is also an important way for a market to test the health of a given company (and sometimes industry). You are publically saying, “I think company A is not a sound investment; in fact, I’m willing to bet money on it.”. That’s a powerful market signal.

The fear is, in a volatile market, selling short stocks may just be a self-fulfilling proclamation. If Entity X is short selling Company B everyone starts to think, “they must know something I don’t; I’m out”. Which can be devastating if say your main business was loaning money to home buyers in 2006.


My Take

And that’s why I’d argue we don’t need less short selling in the future, but more. If we’d had more investors willing to short sell Bank of America, Citigroup and our other large financial institutions in the early to mid-2000s maybe we wouldn’t have had the bubble we did. And if that bubble never happened, then I wouldn’t have to deal with that other kind of short sale I talk about at the beginning of this post!

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2 Responses to “What is a Short Sale anyway?”

  1. Jeff says:

    Very well done, Seth.

    I’m not sure short-selling helps the market avoid bubbles. In the mid-2000s sort-selling was alive and well, yet the bubble still happened. Why? People chase the momentum. Up and down. So, it seems to me, short-selling provides an opportunity to create rapid, downward spiral (you basically say this in fifth to last paragraph).

    I think simple markets work better. The real question is: why do people short-sell instead of just sell? The answer (I think) is that short-selling generally requires less $$, allowing them to leverage their bet. That seems like it would be bad for markets.

    • Seth Neal says:

      Thanks Jeff. I appreciate you taking the time to comment!

      You are certainly not alone in your conclusion. Obviously, if you have some investment group that has a great track record (or say, someone like Warren Buffett) short sell a stock there are going to be a lot of people take notice!! And it would certainly create some downward pressure on the stock price.

      However, if that company is truly sound and profitable it would be little more than a bump on the road. For instance, if Warren Buffett sold short Apple stock 3 years ago I’m guessing Apple would still be fine today because its a healthy company. If we had more people looking at Bank of America and Citibank in the early 2000s and short selling their stocks based on what was going on I think we could have seen a market correction (although, who knows).

      To your last point, the problem with just selling is you need to buy the stock first! Haha! So lets say today you are sitting around with $100 to invest you’re only option is to buy and hope the stock goes up. What if you see a stock that you believe is overvalued; shouldn’t you be allowed to also make money by gambling that $100? After all, if you are wrong its going to cost you MORE than that $100.

      Thanks for reading man!! So appreciate it.

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