The skinny on short-selling
On the Street, the practice is referred to as "shorting" but it has nothing to do with electricity. Short-selling is a financial transaction in which the person sells a stock he or she does not yet own, hoping to buy the required shares cheaper at a later time and make a profit.
It sounds complicated. Is it?
Once you accept the notion that the person shorting the stock is selling a certificate that he or she does not currently own, the strategy becomes clearer.
How it works: Stephen agrees to sell Jack 100 shares of Royal Bank of Canada for $50 a piece. Stephen does not yet own 100 shares of Royal Bank, so he goes to his brokerage firm or another financial institution and, for a small fee, borrows the stock to give to Jack. At some future point, say in 30 days, Stephen has to give the investment house back the shares he borrowed. That means within the next month he will have to buy 100 Royal Bank shares to return to the investment house.So how does Stephen make money? He is hoping that sometime within 30 days Royal Bank shares will tumble below the $50 price at which he sold the stock.
Suppose, for example, that Royal Bank shares drop to $40 sometime within that month. Stephen then buys the stock to give back to the brokerage house, a practice known as covering your short. And he has made $10 a share: $50 he received from Jack minus the $40 he paid for the stock on the open market.
Is it illegal?No. Shorting is a hedging strategy in which a person who owns a particular stock can protect his gains if the stock price drops.
Theoretically, shorting, much like another financial instrument called an option, should reduce wild swings in stock prices.
In response to the recent financial meltdown on Wall Street, Britain and the United States have banned the short-selling of a large number of stocks. The governments believe short-selling was putting downward pressure on already weak markets.
Why do some people resent short sellers?Most investors make money when stocks rise in value. Short sellers, however, want stock prices to drop.
It's a bit like going to a Toronto Maple Leafs home game wearing a Montreal Canadiens sweater. You can do it, but don't expect a round of good-natured applause when you score a win.
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