Jargon Junction: Short Selling

One of the last-minute Leverage revisions requested by my excellent editor concerned how to articulate, in accessible prose, the intricacies of so-called short selling.

His perfectly reasonable query went something like this: Can you, Dear Author and Former Finance Douchebag, in any way, which makes any sort of sense, explain how in the flying fuck short selling works?

My honest answer was: Not really.

Nonetheless, I managed to whip up an entertaining metaphor to depict the nonsensical process and slotted it nicely into the final draft. Of course, to read those words, you’ll have to procure a copy of Leverage.

Since confusion around short selling abounds — and to make your future read of Leverage even more edifying — in today’s edition of Jargon Junction I’ve provided a “streamlined” explanation and “simplified” example.

Content warning: Math.

Simply put, when a trader “shorts” a stock, they’re betting the market price of said stock will decline in the not-too-distant future. As with all finance concepts, unfortunately, nothing’s as easy as it sounds.

To profit from a forthcoming drop in the market price of a stock, an intrepid trader first has to jump through a ridiculous set of hoops. I could attempt to deploy standard English words to describe those hoops, but no matter how hard I’d try, they wouldn’t make a lick of sense. Instead, we’re going to jump right into a concrete, step-wise example which utilizes nice, round figures.

Deep breaths — let’s begin.

AG’s Proprietary Short Selling Case Study (all details fictitious and illustrative):

Imagine an “artificial intelligence” company called Rent Seeking Analytics, whose corporate mission is to eliminate human art and eradicate human joy, trades at $100.00 per share on the NASDAQ stock exchange under the ticker RENT. Presume the firm was founded by prestigious VC funds, is headquartered in Palo Alto, and noted humanitarian Peter Thiel presides over the company as Executive Chairman.

Let’s say we, as good capitalists imbued with wholesome Midwestern values, believe humans are intrinsically decent and worth saving.

More importantly, let’s assume we’ve analyzed Rent Seeking Analytics’ fundamentally flawed business model — annual paid subscriptions lol! — and we fully expect them to whiff on their upcoming earnings report. Let’s also assume we’ve determined — when our “investment thesis” proves correct — the market price of RENT could drop as low as $60.00 per share.

To save humanity from itself and, more crucially, to profit from Rent Seeking Analytics’ pain, we plan to short 100 shares of the stock issued by this corporate paean to misanthropy, nihilism, and techno-libertarianism.

Here’s how we make it rain:

Step 1. To sell 100 shares of RENT “short,” we first have to “borrow” 100 shares from an investment bank, broker-dealer, or analogous financial institution. For the sake of simplicity, let’s assume this transaction is sane (debatable) and easy to execute (mostly). For example, pretend we log into our account at Davos Man Inc., a Swiss investment bank which specializes in funding proxy wars and ethnic cleansing, and proceed to borrow 100 shares of RENT. Of course, Davos Man Inc. isn’t a charity, so they’re going to charge an “interest” fee to borrow those shares, which we’ll assume is 5.0% of the share price (e.g., $5.00 per share at the current market price of $100.00 per share).

Step 2. With our RENT shares in hand, our next step is to sell them into the open (or secondary) market before Rent Seeking Analytics publicly discloses its earnings. We quickly but casually offload our 100 shares at $100.00 per share and pocket the $10,000 in cash (e.g., 100 shares x $100.00 per share = $10,000).

Step 3. We watch with glee as Rent Seeking Analytics reports dogshit earnings — annual paid subscriptions lol! — and “the market” goes into a tizzy. Just as we predicted, RENT’s market price drops to $60.00 per share.

Step 4. We rush back to the open/secondary market and buy 100 RENT shares from panicked investors looking to dump their positions. This costs us $6,000 in cash (e.g., 100 shares x $60.00 per share = $6,000).

Step 5. We “close” our short position by returning those 100 RENT shares to Davos Man Inc. To recap: We borrowed 100 RENT shares from Davos Man Inc., pwned Peter Thiel in the open/secondary market, then returned 100 RENT shares to Davos Man Inc.

Step 6. When the dust settles, we tally up our earnings and pop some champagne. In total, our short bet against RENT netted us $3,500 in profit (e.g., we sold $10,000 of borrowed shares, bought back $6,000 of shares in the open/secondary market, and paid Davos Man Inc. $500 in “borrowing” costs; or $10,000 - $6,000 - $500 = $3,500).

Now, I’m well aware the vast majority of you savvy readers skipped this section, and the few who stuck with me are like:

Believe it or not, because I used my cleverest idea in Leverage, the case study above is about the clearest and most concise example I could conjure. And, to be sure, we’ve barely scratched the surface of short selling’s intrinsic complexities.

We haven’t addressed the trading strategy’s inherent risk (e.g., unlimited possible losses!), nor have we discussed its legitimate applications (e.g., portfolio hedging), illegitimate applications (e.g., market manipulation), or the rare instances where it can be used as a force for good (e.g., exposing corporate corruption).

Suffice it to say, short selling is among the most compelling and controversial trading strategies used in modern stock markets. The process tends to play a part in the wildest financial scandals and, as you’ve no doubt surmised, features prominently in my kickass novel Leverage.