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I have had a number of people write to me over the last few days asking how exactly short selling works and whether I can provide an example. This is a great question and often confuses many traders and investors alike in the market. The primary reason for this is the logic behind selling and buying the shares. When most people think about short selling they think about taking a ’short position’ – that is , a position where they believe the shares are going to fall – but they aren’t 100% sure of how the actual process works. A few people seem to be confusing short selling with the logic of “put options” – and in reality they are very different.
Short selling is effectively – selling what you don’t own – to engage in short selling you need to find a person who owns shares and believes that the share is going to rise. In undertaking short selling, you do think that the price is going to fall. You are effectively “betting against” people who think its going to rise.
The following example should help to illustrate (please note that are differences between naked short selling and covered short selling which are explained in the link at the bottom of this post) :
1. Fred approaches his stock broker and says “I want to short sell NAB at current market rate of $20″
2. The stock broker would approach a large investor who has gone “long” on NAB shares and thinks they are going to rise (i.e. the large investor holds a bunch of NAB shares and thinks that they are going to rise)
3. The stock broker effectively “borrows” these shares from this investor and sells them at the current market rate – deriving a cash sum. The broker is now indebted to the investor for XÂ number of shares and holds cash for Fred.
4. The stock then falls to $18 and Fred wants to cash out and tells his broker.
5. The broker then uses the money from the sale of the shares “borrowed” from the large investor, and buys them at a rate of $18.
6. This costs $18 per share and the stock broker then gives the large investor the number of shares borrowed.
7. Fred has made $2 and pays a premium to the stock broker, who would have in turn been charged a premium from the large investor.
So a proper illustrate in a practical sense:
1. Fred “borrows” 1000 shares at $20 and immediately sells them at market price earning $20,000
2. Stock falls to $18
3. Fred buys 1000 shares at $18K
4. Fred “returns” the “borrowed” shares to the “borrower”
5. Fred keeps $2K profit
6. Fred’s $2K has a “premium borrowing” charge of 10% – so he has to pay this for “borrowing” the shares – $200 to the company.
7. Fred Nets $2K – $200 = $1,800
Obviously, you have to find an investor who is willing to “lend” the shares. Most big investors buy shares to go “long” not short – so many are “hesitant” to do this. However, the reason they do is that you have to pay a “premium” for “borrowing the shares”. Of course, the rationale is that big investors are in for the “long haul” and short selling is really just to gain from “short term” news. To learn more about short selling and the current affects on the ASX – read this article.
The good news is that the RBA has slashed interest rates by 100 Basis Points to a new modern era low of 3.25% – the lowest since 1964. So what does this mean for the average Australian ? Well, the good news is that on a 30-year typical $300K homeloan, a $170 bucks a month will be reduced over the entire life of the loan. This will amount to around a saving of $61K over the life of the loan.
Of course my advice has always been not to reduce your fortnightly interest repayments. Keep them at your current level and you will slash off around 5 years over the course of your home loan. Less on interest, more in your pocket.
Yep, this is the simplest recommendation that anyone can provide when interest rates decrease – don’t go out and spend this interest rate differential – “force save it” by keeping your homeloan and/or other loan repayments high. The higher the better really.
A great video I just watched from Davos is embeded below. It has some of the worlds most powerful leaders discussing the advice they would provide to the US President on Competitiveness. The leaders in this conference include:
Ellen J. Kullman, Chief Executive Officer, DuPont, USA
Rupert Murdoch, Chairman and Chief Executive Officer, News Corporation, USA; Co-Chair of the World Economic Forum Annual Meeting 2009
Duncan Niederauer, Chief Executive Officer, NYSE Euronext, USA
David M. Rubenstein, Co-Founder and Managing Director, Carlyle Group, USA
Ronald A. Williams, Chairman and Chief Executive Officer, Aetna, USA
Moderated by Michael E. Porter, Bishop William Lawrence University Professor, Harvard Business School, USA
Some great points come out of their discussion regarding the state of the United States economy including – in brief summary – the following points:
The panelists comment on the need to create new innovation in energy. Interestingly, they point out the correlation between high fuel costs and the spur for new innovation during the periods of increasing world oil prices but then as oil prices fall – this “urgency” for new innovation in energy subsides as oil falls. This time around, everyone on the panel indicated that lower fuel prices must not mean that innovation stops – all agreed that this time around it must continue.
Increase the level of education at a junior level – a smarter population means that innovative solutions can be presented to problems that seem unsolvable.Â
Increase the level of consumer confidence by ensuring that the level of communication between the Presidential Office and the people in America and around the rest of the world is consistently transparent.
Don’t rush solutions in the first 100 days but rather use the 1440 days remaining in office to fix so many of the issues – time is of the essence but it’s important to note that time is available.
Tax gasoline usage in order to reduce the amount of corporate taxation in the United States so businesses remain in the US and don’t move offshore.
There are a lot of other point worth watching in the video so check it out below and get the rest of your people in the office and/or work place to listen.
I have a bit more time to add some more posts to Small Stocks over the next month or so – so I am looking for posts from you guys regarding the type of content that you want. Please let me know whether you want me to post more content relating specifically to educational articles or whether market commentary is more suitable.
Personally, it seems that so many sites comment on the market generally so I thought I would go down the road of providing educational resources and general trading tips – but please let me know if you want a specific article typed up and I’ll get onto it!
Send me your idea’s via a comment in this post or through the contact page.
