In my previous post, Did Osama bin Laden ever dream of doing this much damage to Americans?, I discussed a movie, The Big Short. But what is a “short”. How do you make money out of a “short”?

Suppose you know for certain the price of some financial asset, say the stock of HiTech Corporation (HiTech) is about to shoot up. Perhaps you’ve heard there’s going to be a takeover bid or maybe they’re about to announce the invention of a super battery that will make electric cars a no brainer.

What do you do? You buy the stock is what you do. If you’re really sure you invest everything you have in the stock. You may even borrow from your bank or broker. This is the usual “buy low, sell high” strategy. In Wall Street jargon buying the stock means you’re “long” on HiTech.

But now suppose you believe the stock is about to crash. Maybe you know the SEC is investigating them for fraud, that their books are a work of fiction and far from being a tech behemoth they’re bankrupt.

Is there any way you can benefit from their impending demise?

There is indeed. It’s called “short selling” and for a detailed explanation read this article in Investopedia.

Short Selling: What Is Short Selling?

Here is the simple version. You “borrow” HiTech Stock from somebody, probably your broker. I’ve put “borrow” in quotes because you’re not so much borrowing the stock as renting it. You pay for the privilege.

Let’s say you rent the stock for four weeks. You sell the rented stock. That’s right, you sell something you don’t own. If you rented a car and tried to sell it, it would be fraud. But you can do it with stock. Four weeks later you buy the stock back and return it to the owner. If the price falls in the interim you make a profit. But if, contrary to your expectations, the price of the stock appreciates you suffer a loss.

Let’s consider an example. You borrow $1 million worth of stock.  The stock price falls by 50% during the rental period:

Proceeds from sale of stock :      $1,000,000

Cost of rental:                                    -20,000

Net proceeds:                                    980,00

Cost of buying the stock back:          -500,000*

Your profit:                                        480,000

*$500,000 = 50% of the $1,000,000 you got from selling the stock.

This is the “sell high, buy low” strategy. Ignoring brokerage and other fees you’ve made a profit of $480k.

Now the broker won’t just lend you stock without collateral. You’d probably have to put up at least $500,000 of your own money. By the end of the transaction you’ve earned a profit of $480k on $500k or, to put it another way, you’ve turned your $500,000 into something just short of a million. That’s a 96% return in one week.

Now let’s see what happens if HiTech stock appreciates by 50%

Proceeds from sale of stock :     $1,000,000

Cost of rental:                                  -20,000

Net proceeds:                                980,000

Cost of buying the stock back:    -1,500,000*

Your loss:                                      -520,000

*Add 50% to the proceeds of the initial sale.

Your sell high buy low strategy turned into a sell low, buy high strategy. Not only have you lost your initial $500k investment, you’re another $20,000 in the hole.

Notice that timing is everything. Even if you’re right about HiTech, if the day after your rental expired the price of HiTec Stock plummets to zero it doesn’t help you. It’s too late. You’re out of the game. You’re wiped out. Which leads to another important saying of Keynes:

Markets can stay irrational longer than you can stay solvent

To put it another way: It’s not enough to know what is going to happen You need to know when it’s going to happen “When” is as important as “what”. As we shall see the Conspiracy has solved the “when” problem. More of that later.

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