One of my favorite movies is the Big Short. It’s one of those movies I could watch a million times. In fact, last week I was hanging out with my brother, Jamie, and since he’d never seen it, we decided to watch it together. At the end, he said, “That’s a great movie, but I still don’t understand what a short sale is. How can an investor make money when the share price goes down? That seems backwards.”
I told him there’s two basic steps to a short sale.
- You borrow shares from an investment firm and immediately sell them
- And then you hope the share price falls so you can buy them back at a lower price and return them.
If you’re right, and the share price does fall, you make money. He looked at me with that smart-alec look that my little brother’s famous for — his face said it all; “Yeah, that didn’t help.”
So I dug into my bag of trusty analogies and pulled out my snowblower story, and it worked. I think it will work for you too. I also roped him into helping me clear my driveway. Let’s head outside and talk about this a little more.
I live in Northern Ontario and last year we were hammered with snow. Let’s suppose that this year, with last winter is still fresh in everyone’s mind, there’s been an early run on snowblowers and stores are sold out. Even if you could get your hands on a snowblower that usually sells for $1,000, it might cost you $1,200. That’s just basic supply and demand. My neighbour, Pete, spends his winters in Florida, and I know that he has a shiny new snowblower sitting in his garage. So I called Pete and asked him if I could borrow it while he’s away.
He said, “Sure, why not? I’m not using it. I’m heading to Florida tomorrow. So I’m not going to need it until next year.” So I picked it up and posted an ad in the local paper to try and sell it … and I did. I was able to sell it immediately for $1,200. That’s like step one of a short sale; I bought a snowblower and sold it at today’s market value. Notice I just put $1,200 in my pocket and in a few months, when the snow starts to melt in the spring, and clearout sales start, I’ll try to pick up a new snowblower, hopefully for less than what I sold Pete’s for. That’s like step two; I buy an identical snowblower to replace the one I borrowed and sold.
Let’s say I was right and I was able to buy one for $900. Look what happens when I return the snowblower to Pete. He’s happy because he has a snowblower back, and I still have $300 in my pocket. In other words, I made money on the decline in the price of snowblowers.
My brother’s always been a bit of a wheeler-dealer, so he totally got this type of transaction. He said, “Thanks, bro! I’m going to give short selling a try. I’m pretty good at picking stocks that go down in value.” Of course I laughed, but then I delivered a pretty stern warning: Where there’s the potential for great reward, there’s usually plenty of risk that goes along with that. I said to him, “What if after I shorted Pete’s snowblower for $1,200, the price actually went up to $1,600 due to steel tariffs or a trade war? I’d lose money because I’d have to buy it back for more than I received in the first place.”
He said, “Yeah, that sounds like something that would happen to me.” Then I took it one step further. “What if I shorted a stock for $10 and the price went up to $50? Or $500? I would lose a ton of money!” You see, there is theoretically no ceiling on how high the price of a stock can go. I’ll leave you with the same thing I told him. With a short sale, you can make money if the price goes down, but you can also lose money if the price goes up…and your losses are theoretically unlimited!