Wednesday, November 26, 2008

Explain like I’m a 5-year-old: Short Selling

Imagine making money during a recession. Have you ever been absolutely sure that a stock is overpriced or that its value is going to decline in the near future? Wouldn’t it be amazing if your UMOO portfolio could almost double in value during a “bear market”? Short selling is probably the easiest and most effective way to get that done.

Most of the people who dare to enter into the world of investing think of it as buying a stock or asset, holding onto it while it appreciates and then selling it to make a profit. “Short Selling” or “shorting” on the other hand is the exact opposite. The investor “shorts” a stock to make money – i.e. he only makes money if the stock goes down in value. This is extremely risky but has the potential for soaring returns. Short selling involves the investor selling a stock that he does not own. You must probably be wondering how he could do that. To put it simply, you short sell a stock that your broker has lent you. These stocks may come from the brokerage itself, a customer of this brokerage or even from another brokerage firm altogether. Once you sell these borrowed stocks, you wait for its prices to drop before you buy them back and then return it to the lender keeping a nifty profit for yourself. However, if the price of the stock rises, you are still forced to buy back the same number of that stock at that higher price thereby sustaining a loss. Like mentioned before, high risks but soaring returns.

Imagine this scenario. After hours, days and weeks of research you come to the conclusion that a company ABC is overvalued at $200 and that its stock value is going to fall in the near future. You decide to short this company and hence you borrow 20 shares of this company from your broker and sell them for a total of $4000. After a week or so the company’s share value drops and it begins to trade at $100. You then buy back 20 shares of the company at this lower price and return to your broker keeping a $2000 profit for yourself.
Interesting isn’t it???

However, shorting does have many risks associated with it. For example, when you borrow a stock, you are responsible to ”cover” if the lender demands his stock back irrespective of whether its value has fallen already or not. The technical term for this is known as being “called away”. Furthermore since you don’t technically own the stock you must pay the lender any dividends or rights declared during the course of the loan. Another potential risk is when a number of investors all try to “cover” the same stock at the same time which would eventually drive the stock price up. This was one of the many reasons behind the Market Crash of 1987.

Imagine a scenario where you did not have to worry about numerous risks involved in shorting. You come to the conclusion that the share value of a company is going south and decide to short it without having to worry about being “called away”. UMOO offers that environment.
If your assessment is accurate, you could really boost your chances of winning the trading tournament that you are a part of. Shorting is especially valuable in the One Day Tournaments that we @ UMOO so frequently hosts.

And while we are at the topic of education and 'talking' in clear language, this coming Tuesday (12/5/08) we are running a community game with Whitney Hoffman, the master mind behind LDpodcast, Podcamp and The Podcamp Foundation. Whitney is all about education, and Education 2.0 and its been a true pleasure working with her and her community on this. The two good-looking Gentlemen at the top of the post are James n’ John Hoffman when they were in the 5-years-old vicinity :)

As Robert F. Kennedy once said “Only those who fail greatly can ever achieve greatly”. You have to be willing to take some risks in order to generate profits.
With Shorts you can do exactly that.

Comments? Questions? We’d love to hear your thoughts what should be the next item in our Explain like I’m a 5-year-old series ?


wsh1266 said...

I think this is a great series- the best thing people can do during this economic tightening is to educate themselves about money, economics and investments for the long term- and Umoo is a great way to practice this before you start involving your real nest egg!

Really looking forward to the game, and having my kiddos play along as well- we'll try investing in some of their favorite companies and see what happens! said...

Thanks Whit, we can’t wait for next Tuesday!