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Short straws

September 11, 2010 Leave a comment Go to comments

Phew! Just my luck: I finally decide to commit to starting a blog when all hell breaks loose with work and I have to pull eighteen-hour days just to keep on top of things. What’s even more annoying is that I actually have a ton of posts in preparation but I’ve discovered that – just like when I’m trying to write a paper – I’m never happy with the results and keep trying to hone and tweak them to an inevitably unattainable level of perfection.

The moral of all this is of course that chasing perfection is a great idea when you’re trying to get a paper published, but it’s an absolutely terrible idea when you’re trying to get a blog off the ground. I shall have to pay attention to this in future.

Anyway, while we’re waiting for the good stuff to come along, I thought it might be worthwhile mentioning a conversation I had at lunch yesterday. I got into a discussion with a colleague about finance, a discussion which took rather a surprising turn. He’s someone whose knowledge on all things physics related genuinely impresses me but he hit me with somewhat of a bombshell half way through our conversation. We were talking about how large – sometimes stupidly large – amounts of money are made each day on stock exchanges by trading in shares. He understood how someone could make money by buying a stock and holding it in the expectation that its price could rise in value. But – and this is a big but – he had no idea how short selling works.

I’ve talked to some other people since then and almost all of them seem to have the same difficulty. I admit, short-selling stocks is a weird idea when you first encounter it, but it really couldn’t be simpler. Here’s how I explained it.

Suppose your next-door neighbour loves video games. In particular, he’s very fond of his Playstation 3 and tries to keep up with all of the latest game releases. Several months ago, he went to Amazon and pre-ordered a copy of an eagerly awaited game so that he’d be sure of having it delivered on its day of release. He waits and waits until, eventually, the release date arrives, his credit card is charged £40, and the postman pops a copy of it through his letterbox. However, being a busy man, he’s due to go on a business trip later that day and he won’t be able to play the game until he gets back in, say, a month’s time.

You’ve been watching his growing excitement about the release of the game with interest. You think to yourself, “Hey, if he’s this excited about the game surely others are too. And if others are excited about it, perhaps there’s a chance to make a few bob here.” (You say this to yourself in your best Del Boy voice.) Knowing that he’s going away for a while – and knowing that the game is in such high demand that there are actually shortages in stores – you ask him if he would mind you borrowing it while he’s gone, promising to give it back to him the moment he arrives back from his trip. In return for allowing you to borrow the game, you might decide to thank him by promising to keep an eye on his house while he’s gone.

Notice that you promised only to give it back to him when he comes home again; in particular, you didn’t actually tell him what you were going to do with the game! Instead of sitting down to play it, you decide to put it to work for you. You go to ebay, say, and place the copy of the game for sale there. You find to your delight that such is the enormous demand for the game, people are willing to pay a huge premium in order to get their hands on it. The ebay auction actually ends with one poor sucker bidder buying the game from you for £80 – double what your friend paid! You smile as your PayPal account grows by £80 and pop the game in the post to the buyer.

A month passes and your neighbour is due back in a few hours. Remembering that you promised to give him back a copy of the game, you stroll down to your local video games store and find – surprise! – that plenty of copies are now available. Even better, they’re available for only £30 now that the initial excitement has worn off. You pick up a copy and on the way home you buy a couple of six packs of beer, one of which is to thank your friend for letting you have the game.

That evening, you smile to yourself as you enjoy your beer.

Contrived though this example is, it captures essentially everything you need to know about short selling stocks. Broadly speaking, a trader will short sell a stock if he or she believes that the stock is over valued or that the stock price will drop over a certain time frame. Although different regulatory requirements mean that the details can sometimes change, the basic procedure is always the same: the trader seeks out someone who already has the stock and asks to borrow it from them for a fixed period of time in return for a small fee. He then sells the stock on the open market and puts the cash in his account. When the time comes for him to return the stock to the person who lent it to him, the trader buys the stock from the market, hoping that its price has gone down in the meantime. If it has, he makes a profit; if it hasn’t, he has to bear the loss involved with buying the stock and giving it back to its original owner.

There are, of course, plenty of reasons why shorting stocks in practice isn’t as simple as this (regulatory requirements, temporary freezes on shorts, managing the dividend payments on stocks you’ve shorted, stock splits that happen during a short, and so forth). Shorting also has rather a bad image among the public. But it’s really quite a straightforward – and ultimately beneficial – practice.

And it’s all done so that you can enjoy that beer when your short comes home!

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