Dear Mr. Berko: Can you please explain, in simple English, what a short sale is, how it works and how it's possible to make money.
My broker tried to explain this to me, but he's too technical and I get lost in his explanation.
He wants me to short one of several stocks that he believes will fall in price this coming winter or spring.
I want to understand this and hope you could you simplify the answer for me.
I know it's risky, but I can handle the risks and it would be fun.
I'm a well-paid commercial artist, and while I'm considered a creative talent, I seem to have little talent for understanding this financial concept.
The broker wants to short-sell Salesforce.com, United Airways or Federal Express.
What do you think of those short-sale stocks?
— VG: Detroit, MI
Dear MI: As you may have been told, a “short-sale” is a technique that allows investors to make money when a stock falls in value.
Yes, Virginia, investors can also make money if the values of Federal Express (FDX-$86.13), United Airways (UAL-$19.50) or Salesforce.com (CRM-$144.30) decline.
And while I think there's a fair chance the shares of UAL and CRM could fall in price by the spring of 2013, I'm less sanguine about FDX.
But that's why you pay your broker big bucks and only a dollar for this paper.
One simple explanation is that selling a stock short and hoping it falls in price is actually the analog of buying a stock and hoping it rises in price. However, the word “short” indicates you don't have the stock you are selling. Here's how it works. Assume it's a waxing gibbous moon and Countess Dracula — aka Mrs. Dracula — discovers the Life Sciences division of Bio-Rad Labs (BIO-$100.40), due to an unexpected product shortage, will be unable to produce Lucolyte 2-X/B, its best-selling, most profitable blood additive used for vampire agranulocytosis.
Therefore, when BIO's Life Sciences runs out of product, its revenues and earnings will fall by 66.6 percent. BIO is keeping this news quiet, hoping its science team, that was dispatched to Transylvania after rumors compelled them to investigate the existence of a secret cache, will be successful.
Later, the Countess was informed, with certainty, that Vlad the Impaler destroyed the cache in the early 16th century.
Next, Countess Dracula called Franklin Stein, her broker at Lugosi, Karloff, Chaney & Price Securities and commanded him to sell-short 100 shares of BIO at $105. Because LKC&P Securities didn't have 100 shares of BIO, they borrow the shares electronically from another client, selling them on the NYSE at $105, which results in a $10,500 credit to the Countess's account.
Several weeks later, the science team trudges back from Transylvania. BIO issues a report to CNN that it can no longer produce this profitable product and within a fortnight, its shares fall like a stone to $55 a share.
At this point Countess Dracula calls her broker, Franklin Stein and commands him to buy back the stock. This is known as “covering the short position.” Franklin Stein purchases 100 shares of BIO using $5,500 from the $10,500 credit in the Countess's account. The 100-share certificate is electronically returned to its owner. Countess Dracula then keep the difference between the sales price $10,500 and the repurchase price $5,500 which becomes a bloodless profit of $5,000. This same technique can be used for bicycles, artichokes, eggplants, bunny burgers or season's tickets to the Detroit Lions.
A short sale is no more speculative than buying a stock (in the vernacular buying a stock is called “going long”). However, selling short supports “Berko's 50/50-90 Rule” about investing: “If there's a 50/50 chance that two stocks will fall in price, there's a 90 percent chance that the one you pick won't.”
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at firstname.lastname@example.org.