Please explain "shorting" to a novice

[James Boston]

First of all, I don't plan on doing any of this, so advice on why I shouldn't won't be necessary. I just want to understand it.

I read Peter Lynch's layman explanation of shorting as the equivalent of borrowung something, selling it, and buying a replacement at a lower price to pocket the difference. But how does this actaully apply to stocks? Does your broker credit your account based on the current stock value, allowing you to profit from the difference when you buy the stock at a lower price? Do you actually own the stock at any point? I'll let others clarify before I confuse the matter any more.

[BradleyT]

I'm borrowing and selling 1000 shares of Yahoo at $30, so I'm getting $30,000. A month later I want to close my short position so I have to come up with 1,000 shares to give back to the person I borrowed from (this part is transparent however there MUST be shares available to actually short). Hopefully I only have to pay $25 per share or $25,000 to get back the 1,000 shares I borrowed and sold. If yahoo jumped to $50, I have to pay $50,000 to get those 1,000 shares back.

Essentially you can only make 100% profit on shorting - if yahoo went to $.01 I would only have to pay $10 to get those 1,000 shares back - but you can lose an infinite amount - yahoo could go to $3000 per share and I'd be bankrupt. Your position would get called before that happened though.

[OrangeCat]

This explains it pretty well:
http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

[tanda]

In addition to what the others wrote, you must also pay interest on the borrowed stock.

[BarkingMad]

[ QUOTE ]
But how does this actaully apply to stocks?

[/ QUOTE ]

From a practical standpoint, shorting is as easy as clicking your mouse (once you have a brokerage account).

Understanding what goes on behind the scenes after you place your order to sell short is important, but most explanations I've read invariably make it seem complicated when it's not.

[ QUOTE ]
Does your broker credit your account based on the current stock value, allowing you to profit from the difference when you buy the stock at a lower price

[/ QUOTE ]

No. Money will not be credited to your account when you sell short.

You click your mouse on the "sell short" button at your brokers website, and the process of borrowing and then selling shares happens almost instantly.

BradleyT gave an 'OK' shorting explanation, but he left the door open for confusion when he said "I'm borrowing and selling 1000 shares of Yahoo at $30, so I'm getting $30,000"

To clarify, there will not be $30,000 hitting your account while you are "short". Your account is adjusted
for trade profit/loss after you exit the trade.

When you want to exit your position, you click the "buy to cover button", and you buy shares back on the exchange and return them to your broker (who you borrowed from). This also happens almost instantly.

Lance

[OrangeCat]

[ QUOTE ]
...however there MUST be shares available to actually short...

[/ QUOTE ]

That's right. Not all stocks can be shorted. Or more precisely, the average customer will not always be able to borrow the shares in order to make the short sale. I found this out when I tried to short TZOO and TASR in late 2004.

[OrangeCat]

Another good article about short selling
http://www.thestreet.com/funds/smarter/862233.html

[Mark1808]

[ QUOTE ]
In addition to what the others wrote, you must also pay interest on the borrowed stock.

[/ QUOTE ]

Actually you can earn interest on the proceeds of your short sale. Larger investors can negotiate better terms here but their is an alternative for the small investor and that is a "synthetic short". Here the investor buys a put and sells a call with the same strike price and expiration date. The "synthetic short" moves the same way as a short sale but arbitrage lets the investor sell at a slightly higher than market price, the differance is the implied interest earned on the short sale.