The Ins And Outs Of Shorting Stocks

By Motley Fool Staff Markets Fool.com

Snap recently IPO'd, swelling to lofty valuations while its management team is giving less-than-inspiring reports on the company's strategy and future plans. Many investors are wondering if this might be the time for a short play.

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In this clip from Industry Focus: Tech, Jason Moser and Dylan Lewis explain what shorting is, how it works, and a few of the many huge reasons that it's such a dangerous play to make with any company -- significantly more dangerous than going long -- and why it can be a losing move even when your theory on a company turns out to be totally correct.

A full transcript follows the video.

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This podcast was recorded on March 10, 2017.

Dylan Lewis: I think, before we get too much into the downside, we should walk through some of the mechanics of shorting itself and what you're really doing when you're shorting a stock.

Jason Moser:Yeah. Shorting a stock, first and foremost, is basically placing a bet on its demise. You're betting against it. Normally, what we do so much of here is recommend that people buy stocks, and we think those are going to be good investments for the long haul, they will appreciate in value. When you short a stock, you're basically betting that stock is going to fall or depreciate in value. There could be any number of reasons you short, but ultimately, you're basically borrowing a stock from your broker, selling it to someone else at a given price, and then at some point, you're going to need to buy it back and return it to the broker. So, if you short a stock, then ideally, you want to see the price go down after you short it, so you would be able to buy it back at a lower price. You get to pocket the difference.

I think the biggest problem I have with shorting, and to the question that the listener was asking, is, if you think about it: When you buy shares of a company, when you invest on the long side, the very worst case scenario is you lose all of your money. So if you invest $1,000 in company XYZ and company XYZ goes bankrupt, you might lose your $1,000. And that sucks, no one wants to do that. But that's the downside. It's quantifiable. The thing with shorting the stock is, you can lose a lot more than 100% of your money. You short a stock XYZ at $100 a share and then XYZ takes off and six months later it's $500 a share, well, you're stuck, you've lost a lot more than 100% of your money. I think that's probably the scariest part, to me, about shorting. There's far more downside than if you were just going to buy shares of a company and hold on to them as a long investor, like we do.

Lewis:Yeah, I think the best way to think about it is, you take the upside-downside of going long and flip it. That's basically what you're looking at. As a super basic example here -- and a lot of what we're going to be talking about on this show is basic shorting, not working with any options in addition to a short position, just to keep things simple. But, say you borrow one share at $10, you're selling it immediately. $10 gets deposited into your margin account. Then you have one of two scenarios playing out. Say shares are at $7 a week later, at which point you would probably buy a share and then return it to your brokerage, pocket the $3, maybe minus any fees or anything like that. Scenario B, shares are at $13 a week later, in which case you'll probably get a call from your brokerage saying, "We need you to put more money into this margin account to cover the losses, because right now you can't do that with only the $10 that is currently in your account."

Moser:Yeah, and that's a good point. A lot of this stuff is out of your control at some point, maybe. When you're borrowing those shares to then sell them off to someone else, you can't just do that for as long as you want to do it. There are a lot of other factors at play that could dictate what you have to do at some point in the future. Whereas you could buy shares ofAmazontomorrow and hang on to them for the next 20 years if you want, and nobody can take it away from you unless it's taken private or acquired by someone else, and, obviously, that's not likely to happen. But with shorting, it seems like you don't have the same freedom there.

Lewis:I think one of the other dangers that we see with shorting is this idea of getting a margin call, and being in this position where you've already made that initial bet, and then you're going to have to decide whether or not you want to keep going at it and keep banking on that short position and that thesis against that company, or if you ultimately want to buy shares at the market price, which is above your position, and just eat the losses.

In that second example, if you decide not to put more money in your margin account, basically, you'd wind up buying shares back at the market price, which would be $13, and you would close out the position and eat the $3. Of course, you could put more money in your margin account, and shares could go up to $15 or $20, and then you're back in the same predicament. So, you could wind up in this incremental [situation]. Keep digging in the hole, and it keeps getting darker and darker, and dirt keeps going up on the ground, but you can't see the sun.

Moser:Yeah, it's funny, shorting, to me, is one of those situations where -- and I don't do it, I'll be very clear, to me it's not worth it -- but you could be totally right in theory. If you come up with a thesis as to why to short a stock -- "This company's cash flow is not as good as they report," or maybe you think management is crooked, or whatever you think it is -- you could actually be totally right, but there's that saying: The market can remain irrational far longer than you can remain solvent.

Lewis:Which is a big concern.

Moser:Yeah. At the end of the day, the market is going to have the say-so in this. To me, shorting a stock, you could be totally right and still totally lose, and there's nothing you can do about it.

Lewis:And to that point, in a lot of situations you're basically paying to watch your thesis play out, because very often, there's a stock loan fee associated with shorting. So, unlike when you're long and you buy shares, and you probably pay a commission to buy your shares, that's it. You hold them, you hold them for as long as you want, and you can watch the stock go up and down and just enjoy the entertainment there, in addition to seeing what goes on with your portfolio. But as you hold or maintain a short position longer, it's going to cost you more money in fees.

Moser:Yeah, you're paying for it.

Dylan Lewis has no position in any stocks mentioned. Jason Moser has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.