Chapter 20



Chapter 20.d

Stock Market: “Going Long and Selling Short”

Going Long: when we own a stock we are in a “long position.” The owner benefits when the stock gains in value, and the profit is unlimited. So the “long” profit is said to be “bullish.” When the stock is down the most that the owner can lose is the amount of money he has originally paid for it. It is impossible to lose more, since owners have “limited liability.”

Selling Short: this concept is about borrowing and selling. The borrower borrows a stock from an owner in exchange for an IOU, and then sells it to a buyer. When the market value of the stock is down, the borrower buys it and returns to the original owner (see Figure 20.d.2).

This way the person, who’s in the “short selling” position, gains profit when the stock drops in value. The maximum profit is equal to the amount the stock was originally purchased for. However the maximum loss is unlimited (See Figure 20.d.3). That’s why short selling is considered “bearish.”

Pros and Cons of Short Selling

Lender’s Incentive to Participate – There is no risk of losing for lender, so he has no reason not to participate in short selling.

Breaking the Deal – If any one of the participating parties decides to break the deal, (i.e. lender wants his stock back or borrower wants to return the stock), the participant who doesn’t want out meets a broker who rematches him with another owner/borrower.

Voting Rights – The only one who has voting rights is the one holding the genuine stock. Once the original owner lends the stock away he gives away his right to vote. In the case when voting is truly important to the original owner, he can borrow a stock for the time of voting and the return it.

Dividends – Again, only the holder of the genuine stock is paid dividends by the firm. The firm keeps track of the stock through transfer agents. Since the lender loses dividends by selling short, the short seller must compensate the lender by repaying dividends.

Rate of Return – The rate of return is normally negative for the short seller, for the same reason that the rate of return to a long position is normally positive. To compensate, the short seller can put the money he got from the sale of the stock in the bank and pay lender with the interest earned.

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$60

-$60

-$30

$0

$40

$100

P

STOCK

$30

"

Figure 20.d.1

Suppose a stock is purchased at $60, if the stock value doesn t change the owner s profit will be $0.

If the stock grows in value up to $100, the owner s profit is $40.

If the stock price drops -$60

-$30

$0

$40

$100

P

STOCK

$30

∏

Figure 20.d.1

Suppose a stock is purchased at $60, if the stock value doesn’t change the owner’s profit will be $0.

If the stock grows in value up to $100, the owner’s profit is $40.

If the stock price drops to $30, the owner’s loss will be $30.

Notice that the positive profit that can be made is infinite, however, the loss is limited to the negative value of the stock (-$60).

Figure 20.d.2

The short seller borrows 1GM Stock from OWNER in exchange for the borrower’s IOU.

The borrower sells 1GM Stock to a buyer for $60.

What the short-seller gets:

The market value of 1 GM drops to $50.

The borrower buys 1 GM Stock for $50.

The borrower returns 1 borrowed GM to the owner.

The borrower’s profit is ($60 - $50) = $10.

$60

$60

-$10

$0

$10

$70

P

STOCK

$50

∏

Figure 20.d.3

Suppose the borrowed stock has a present value of $60; if the stock price doesn’t change the short seller’s profit will be $0.

If the borrowed stock goes up in value up to $70, the short seller’s loss will be (-$10).

If the borrowed stock drops in value up to $50, the short seller will make a $10 profit.

Notice that while the loss is unlimited, the gain will not exceed $60.

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