Short-Selling Defined

What a week. Though a lot of people have been predicting an economic downturn for the last while, I don’t think anyone anticipated how bad it might get. And if they did, may they should have done us all a favor and not kept their mouths shut. It’s the kind of news that needed sharing!

One of the things that happened in an extremely active financial week was an international ban on short-selling, something investors would have thought impossible even a few months ago. From The Wall Street Journal:

The Securities and Exchange Commission, along with the U.K.'s financial regulator, the Financial Services Authority, banned short selling of a large number of financial shares. The SEC's action involves 799 financial companies and is slated to expire Oct. 2, with a possible short-term extension.

This came up over dinner with friends last night and I realized anew how incomprehensible even the idea of the short sell is to people who haven’t had intimate contact with the best and worst of the stock market. Then I saw it really, really poorly explained on CNN and I remembered that
the major plotline of my first novel, 2004’s Mad Money, revolves around the short-sell. I think I did a pretty good job of explaining and defining the basics of short-selling in that book.

Here it is, boiled down all tight, as narrated by Madeline Carter in Mad Money. I hope it helps clarify at least this aspect of the present insanity:

Short-selling is an odd phenomenon, something exclusively the domain of the stock market. I’ve tried to come up with real world parallels and I can’t. It’s completely counterintuitive: it goes against everything you’ve ever been taught about how monetary interaction works... outside of the stock market.

A short-sell is when someone sells stocks they don’t own in anticipation of the stock price going down. When that happens, the seller can then cover their position by buying the stock they’ve already sold at a much lower price than they bought at, pocketing the difference. There’s the potential to make a lot of money in between. Sell at two dollars. Stocks you don’t own. Buy later at one dollar to replace the stocks you already sold. You keep the buck in the middle. The hitch is, in order for this to work -- in order for you to make money -- the stock has to go down. It simply must.

In a short-sell the risk is huge. There’s only a certain amount a stock can drop: if you’ve bought in the traditional way, once you get to zero, you’ve lost it all and you can just write it off. But there’s really no top on how high a stock can go: in a short-sell that backfires you can lose an infinite amount of money, because the stock could just keep rising forever.

There had been times in the past when I’d been so confident a stock was going to tank that I’d seriously considered short-selling it. But, in the end, I couldn’t make myself do it. There’s nothing actually wrong with short-selling: from a legal perspective or otherwise. I just can’t get my head around the part where you have to wish for a stock to go down instead of up. Like I said, it’s counterintuitive and intuition plays a larger part in my shtick than I tend to admit in public.