Wednesday, March 18, 2009

Shorting in a real world example

There's been a lot of shorting of stocks this last month.

It's the opposite of what you'd normally do with a stock, which is go long. You buy a stock at a low price in hopes that you can sell it in the future for a better price, and make a tidy profit.

I thought I'd put shorting a stock into something a little more visually aiding since most of the trading we do with stocks these days is in electronic format.

The two principal ingredients to shorting are being able to borrow an object from someone and being able to return an equivalent/equal object back to them.

Say I have a neighbor across the street that has - for some inexplicable reason - 5 brand new Toro lawnmowers. He's not using them since it's late winter early spring and won't need to cut his grass for another two months.

Let's say I have a friend who has more winter grass that needs to be cut earlier in the growing season and he needs a new Toro lawn mower. Unfortunately, no local hardware stores have the model that my friend needs yet my neighbor has 5 of them!

I also have some privileged information knowing that one dealer will have some new Toro lawn mowers (the same type my neighbor has) in stock in about a month and at a price of seven hundred dollars.

Here I notice an opportunity and maybe in this scenario it's a little underhanded.

I tell my neighbor I'd like to rent one of his five lawn mowers for 100 dollars for a whole month. My neighbor agrees stating he'd like the lawnmower back in a month's time.

I take the lawn mower and sell it to my friend for one thousand dollars. He's happy.

Now I'm a bit of a risky position since I'm expecting the dealer I mentioned above to have the equivalent mower at seven hundred dollars in about a month's time.

Let's say everything works out. In another thirty days I do go to the dealer and buy the new mower for seven hundred dollars. Since my neighbor wants his fifth mower back after the month's rental period I return the new mower I just bought back to him. He doesn't know the difference.

So, here I sold a mower to my friend for one thousand dollars. Later I got an identical one for seven hundred dollars and gave that one to my neighbor. Minus the rental fee I made two hundred dollars.

So it was profitable being a middle man for someone who was willing to rent to me his item so that I could sell it at full cost to a buyer now, and then, at a later time give him the same "equivalent" item back to him that I bought at a much lower cost.

That's the essence of short selling.

But the risk is if the dealer I buy from suddenly increases his prices to more than I sold the mower to my friend, then I'm out of some money. The short seller gets squeezed and loses a tidy sum! I can't say to my neighbor I can't return his mower right?