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Can you explain what mean when say they're "going long" with a stock versus selling a stock "short"?
-- Randy, Charlotte, North Carolina
Ever have breakfast in a coffee shop and hear the guy behind the counter yell into the kitchen for an order of "whiskey down"? That's short-order cook lingo for rye toast (rye as in whiskey and down as in put it in the toaster and push the handle down).
Well, virtually every human activity develops its own jargon that seems natural to those who use it every day but may come off as utterly incomprehensible to outsiders. And the world of investing is no different.
In fact, the investing arena is chock a block with phrases and expressions that cynics might even say are designed to keep poor old individual investors in the dark.
The long and the short of investor jargon
Which brings us to the long and short of it -- that is, an explanation of what investors mean when they talk about going long vs. going short, or selling a stock short.
When they invest money in stocks, the vast majority of investors "go long." That is, they plunk down their money, buy the stock and hold it in the hopes that the stock's price will rise in the future so they can sell it for a profit. In short, they're hoping to "buy low and sell high" as the old adage goes.
So, for example, if you believed that over the next few months that Microsoft's stock was going to rise from its recent price of $26 a share to, say, $36 a share, you might buy 100 shares, figuring you would grab a $1,000 profit if the stock rises as you expect. (For simplicity's sake, I've left out sales commissions. Also, I use this scenario only by way of illustration. I'm not advocating that anyone engage in short-term trading of stocks.)
But there is another group of investors that looks for stocks they believe are heading not up but down in price, at least over the short term.
Perhaps they believe the company has financial problems that will come to light, or maybe they feel competitors will be coming out with better products that will put a dent in the company's earnings. Or perhaps they just feel the stock is wildly overpriced, that investors have bid up the price of the stock to an unsustainably high level from which the stocks is bound to fall.
So in order to profit from what they believe is the stock's imminent drop in price, these investors "go short," a process also known as "selling short."
Essentially, they borrow shares of the stock from their broker, sell those shares at the current market price and then hope to make a profit by replacing the borrowed shares with shares they'll buy on the market after the price of the stock has dropped. In other words, these investors -- known as "short sellers" -- want to "sell high and buy low."
So, going back to our Microsoft example, if a short seller thought Microsoft shares might drop over the next few months or so from their recent price of $26 to, say, $16, they might borrow 100 shares from their broker and sell them, generating $2,600 in proceeds.
If the stock did indeed fall to $16, the short seller could then "cover" his short position by buying 100 shares of Microsoft for $1,600. Subtract the $1,600 it cost you to replace the borrowed shares from the $2,600 in revenue generated from selling the borrowed shares, and you've got a tidy little profit of $1,600 -- assuming all goes as planned.
Ah, but what if Microsoft shares don't cooperate by falling in value. What if the price of those shares climbs instead from $26 to $28 to $32 and still shows no sign of reversing its upward path?
Let's say that when the price reaches $36, you finally decide that perhaps the stock isn't going to drop below $26 anytime soon, so you want to get out of this investment. In that case, you would cover your short position by buying 100 shares of Microsoft at $36. Alas, you've now had to shell out $3,600 to replace shares you borrowed for $2,600 -- which means you've lost $1,000.
Short selling is risky business
In fact, short selling can get more dicey than this little example. That's because brokerage firms typically let you put up cash equal to as little as half the value of the securities you're selling short. So you might have to put up just $1,300 to sell short 100 shares of Microsoft at $26.
Doing this magnifies the return on your original investment if the short sale goes your way. If Microsoft stock goes down to $16 and you sell for $1,000 profit, you've earned $1,000 on an initial investment of just $1,300 -- a 77 percent return vs. the 38.5 percent return you would have on an original investment of $2,600.
You would also have to pay interest since your broker is lending you the difference between the $1,300 you put up and the $2,600 amount of the short sale, but to keep things simple, we'll ignore interest cost in this example.
But if the stock rises in value, borrowing works against you and magnifies your negative rate of return. Your $1,000 loss would translate to a 77 percent loss on $1,300 vs. a 38.5 percent loss had you put up the entire $2,600. You would have only $300 of your investment remaining.
In fact, if Microsoft shares had risen further before you decided to cover, you could be in even worse shape. If you had waited until they hit $46, for example, you would have shelled out $4,600, giving you a loss of $2,000, wiping out your entire $1,300 and requiring you to throw in another $700.
Actually, your brokerage firm wouldn't have let you rack up losses beyond your original investment, unless you agreed to put up more money. When the value Microsoft shares rose above a certain point, you would have received a "maintenance call" from your broker, asking you to put more cash or securities in your account to cover the growing loss. If you failed to do this, the broker would cover the short and close your position and you'd be stuck with any resulting loss.
Bottom line: it is possible to make money whether stocks rise or fall in value. But selling short is riskier because there's more of a timing element involved.
If I buy a stock outright -- that is, go long -- and it goes down in value, I can decide to hang on without investing more money if I believe the stock's prospects are still good. But if I short a stock and it rallies strongly, I'll have to put in more cash. And I'll have to keep putting in more if it continues to rise.
Essentially, this means the loss potential is much greater in shorting than in going long. It also means that to make money by shorting, you've not only got to be right about the direction of the stock; you've got to be right about it in a pretty short time period.
So given all this, I think most investors should stick to going long and leave short selling to pros who specialize in this sort of thing.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."