Thursday, March 10, 2011

Understanding Shorting Stocks

When talking about the markets people sometimes ask me to explain what it means to "short" a stock.  It is a little easier in person because I can use props and live people to show how it works. 

Imagine there are 3 people who live on a street.:  Dave, Cindy, and Mike.

Dave has 1 share of Netflix stock worth $200. 

Cindy wants to "short" that share of stock. 

Cindy then tells Dave she wants to borrow his 1 share of Netflix.  She tells him that she wants to keep it at her house for a few weeks.  Dave agrees and tells her to treat it good while she borrows it.  He loves that Netflix share.

Cindy then takes Dave's Netflix share and sells it to their neighbor Mike for $200.  She puts the $200 in her pocket and now the share of Netflix is sitting at Mike's house.  Poor Dave is at home watching old movies without his Netflix, not even realizing what is taking place across the street.

A month goes by and Dave calls Cindy to ask for the share of Netflix back.  She says okay, picks up the phone, and tells Mike she wants to buy the share back.

Here's the nice part for Cindy: the stock today, a month later, is only worth $190.

Mike gives her back the share of Netflix in exchange for $190.  Cindy then brings the share back across the street and gives it to Dave.

Everyone is back to where they started, but Cindy now has $10 in profit in her pocket.

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