Business side of ‘The Big Short’: What is a ‘short sale’?

Business side of ‘The Big Short’: What is a ‘short sale’?

Everyone knows you can make money in stocks when they’re going up. But do you have to lose money when they’re going down? Nope. Enter the wonderful world of short sales and margin accounts.

Wandering in disbelief through the suddenly vacant offices of the venerable but now bankrupt firm of Lehman Brothers. (Video promo still taken from the trailer for Paramount Picture's film "The Big Short")

WASHINGTON, February 21, 2016 – Like a complex movie murder mystery, there’s no way for the layman to get from Point A to Point B in “The Big Short.” This surprise hit film, which first hit the silver screen in late 2015, reflects (but compresses) the almost impossible-to-believe real life story behind the 2007-2010 financial collapse of major U.S. markets and firms that caused the Great Recession.

But to fully comprehend how the heroes of this unusual film actually made money out of this epic disaster that destroyed so many, filmgoers need to quickly get up to speed on the seemingly peculiar Wall Street beast known as “the short sale.”

Read also: ‘The Big Short’ deserves an Oscar for telling the truth

When most people think of investing in stocks, for example, they imagine that you start out by buying and accumulating shares in a great company. Next, you let those shares sit in your account, perhaps even collecting a dividend now and then as you wait and watch in delight for its share price to go up and up. At some price you have (hopefully) set, you then sell your shares to make a profit.

Fixed income investments (i.e., bonds for the most part) can be traded in much the same way though their prices generally don’t move enough to make trading them worthwhile.

Collectively, stocks, bonds and similar investments are known as “securities.” And the way most people think securities work is that you make money when they go up and you lose money when they go down.

But you can also make money on securities when they go down. Since in real life, no stock or bond always goes up, it’s a really good thing to know you can make money by placing the opposite bet, called a “short sale,” or, in Wall Street parlance, “shorting” or “going short.” That’s simply the opposite of buying and owning a stock or “going long.”

Here’s how a short sale works:

We’re accustomed to searching for stocks we think are going to go up. But sometimes, you can also discover securities you think are about to run into serious financial trouble, enough that they’ll decline or perhaps even collapse in price. Buying such a stock, you reason, will lose you money, so quite logically, you stay away from it. But what if you could actually make money when this stock goes down? You actually can, by going short. But for a variety of reasons, this is a trickier and riskier maneuver than simply buying shares of a given stock outright.

In a “normal” stock transaction, you buy shares, leave them in your account, and sell them at a later date. In these “long” positions, you are “long” the stock. I.e., you own shares of stock.

In a short sale, however, you borrow shares of a stock you don’t own, and then immediately sell them for the going price on the open market. You’ve now shorted the stock. You don’t own it. You borrowed it and immediately sold it. And the proceeds of that sale are sitting right now in your account, essentially as a credit.

Now, if the gods are smiling and if your research or educated guess is right, the stock you shorted will get hit with some bad news—a government or class action lawsuit, bad PR on the evening news, or, most often, horrendous or even slightly unexpected negative earnings. If your stock is widely owned and if its current owners start dumping the stock in a panic, it will frequently sink like a rock. (Ask investors in Yahoo! how that works.)

If the stock you shorted is doing a Wile E. Coyote off the cliff, that’s just what you wanted. Depending on the lowest price you’ve determined for this stock, you then re-enter the market and buy those shorted shares back at the lower price.

Let’s do the math

Forgetting commissions for the moment, if you buy 100 shares of XYZ Corp. at $10 per share ($1,000), wait a while, and then sell them later at $20 per share ($2,000), you now have a nice profit of $1,000. That’s how you make money on the long side.

But let’s say you think XYZ Corp. is a disaster waiting to happen, and think its next earnings report, coming up soon, will be flowing with red ink, perhaps you’ll decide to take the opposite bet. If XYZ is currently offered at $20 per share, you simply borrow 100 shares from your broker and sell them for $20 per share ($2,000). If you’re right a few days later about those horrendous earnings and the stock quickly plunges to $10 per share ($1,000), you go in and buy back the shares you’ve borrowed, hand them back to your broker (effectively), and pocket the difference: $1,000.

Where did that strange profit come from? Easy. You first sold someone, somewhere, 100 shares of XYZ at $20 per share you borrowed from your broker, only to buy them back later at a deep discount of $10 per share. You just made $1,000 on a stock whose price was cut in half. It may seem strange, but it works in real life.

Where things get complicated: Margin accounts

Of course, if you look behind the curtain, you’ll find that things are a little more complicated than what we’ve just related. It’s time to answer some burning questions that will help shed light on what happens in a brokerage firm’s back office when you launch a short sale..

How can I just “borrow” stock from my broker? If I borrow money from the bank, I have to pay interest as well as eventually paying the principal back. And, oh, yeah, where do those shares I’m “borrowing” actually come from?

You can’t just borrow stock from your broker. You can only transact a short sale in what’s known as a margin account. To set up a margin account, you need to provide your broker with some documentation of your net worth, though not anywhere near as much as you would for a home loan.

Under Federal law, a broker can’t qualify you for a margin account if you don’t have enough money or assets to take the risks inherent in a short sale. Hence, you provide some documentation and sign a lengthy and somewhat confusing form.

Most individuals who are reasonably okay financially can qualify very quickly for a margin account. Which is where things get more interesting.

When you short a stock, you have to borrow those shares first. And borrowing shares, like borrowing money, involves paying interest on what effectively is a loan. I.e., your broker is loaning you the shares and you’re promising to buy them back later and return them to the kitty.

In the meantime, you’re paying daily interest on the original value of the shares you borrowed. When you buy the stock back, accounts are settled and you’re no longer charged this “margin interest.”

In other words, a short sale will cost you interest in the short run, which is why most short sellers don’t want to hold their position for very long—it will erode at least a small portion of the profit they are eager to make.

Where do the shares come from that you borrow?

From someone else with a margin account, that’s where. When you open a margin account, you can buy, sell or short shares in that account. But this also means that you’re making your shares available for someone else with a margin account to short if they so desire. This transaction is always transparent.

Example: You, Investor A, own 100 shares of ABC Corp. in your margin account. Investor B, who doesn’t own any ABC, wants to short 100 shares. So your broker simply gives Investor B your 100 ABC shares, which he promptly sells short in the market. Perverse? Not really. For, if you want for some reason to get rid of the ABC shares you own tomorrow, your broker just grabs 100 shares from Investor C and sells them on your behalf.

Bookkeeping wise, you never see those 100 ABC shares disappear from your account until you actually sell them. Your broker’s accounting always credits you with those 100 ABC shares until you sell them, no matter where those shares might actually be.

If this all looks like a shell game, it sort of is. But in my own lengthy time investing in the market, my brokers have never lost track of anything I owned. (Obviously, that’s one of the reasons why the investment banking industry operates an armada of computers and backup systems to track everything.)

What if my short sale goes against me and the stock starts going up, big time?

The simple answer is that you could be screwed.

Longer answer: before you undertake any short sale, you have to determine in advance how much of a hit you’re actually willing to take before you get out of the short sale. If the share price of ABC hits that point (called a “stop”) you just get out, perhaps a bit irritated but none the worse for wear.

Always remember: if you invest in stocks, you don’t always win. If you can’t bear the thought of losing, then don’t invest in the market.

The trouble with margin calls

You can follow the stock and use a “mental stop” at get out manually by calling your broker and telling him to sell, or by doing it yourself if you run your own investments on your personal computer. Alternatively, you can enter a “stop-loss” order that stays on the books and is triggered whenever the stock hits that price.

But here’s the really bad news. Suppose you were totally and utterly wrong about that short sale, and ABC starts heading up to the stratosphere. Margin account rules dictate that you maintain a certain amount of “equity” in all investments, long or short, that involve borrowed money in the account.

If your losses exceed a certain percentage of that equity, you’ll get a call (or perhaps an email) from your broker asking you what you want to do to correct the situation. Usually, that means ponying up more money—almost immediately—to restore the equity balance.

If that’s the case, and if you either don’t come up with the money or if you’re on vacation and can’t be reached, your brokerage is authorized to “sell you out;” that is, close out your short by buying it back at whatever price, plus selling enough other investments out of your account to restore your equity to required levels.

My broker can do this without my permission? Yes he can. It’s all part of that margin account agreement you signed earlier. (Hah! Did you read it?)

In the margin account (which consists of a lot of perfectly legal but real life “fine print”), you agree to allow your broker to borrow your securities, charge you interest when you transact actual margin-eligible investments—and sell you out at any time if your margin account gets stressed and requires more equity.

If all this stuff freaks you out, remember: you can always remain in a “cash account” at your brokerage. That’s an account where no one can borrow your shares. But it’s also one in which you can’t buy stocks on margin (borrowed money) or sell them short.

What your cash account loses in flexibility, however, it gains for your peace of mind, at least most of the time. In the end, it all depends on how comfortable you are messing around on a day-to-day basis with borrowed money or stock.

Please keep in mind that everything we’ve just told you about short sales and margin accounts isn’t some elaborate corporate hanky-panky. The U.S. government (via the SEC and other agencies) has set these rules and brokerages need to follow them, or else. Otherwise, under even the slightest financial stress, the whole system could go completely haywire…

Back to “The Big Short”

…which is precisely what happened in “The Big Short.” When everyone suddenly discovered that those supposedly insane investors and firms shorting all those weird securities (CDOs) assembled from risky mortgage loans were actually dead right to do so, investors holding those risky securities dumped them so fast and hard that they just about wiped out America’s biggest financial organizations. Between 2008 and the spring of 2009, many of those investors themselves were wiped out.

But the guys in the film who spotted the obvious rottenness hiding inside those bond-like “tranches” of unequal mortgages sold them short. In taking this huge risk, they actually won the battle, ending up with the kind of epic payday that Powerball lottery winners could only dream of.

But if the contrary players at the center of “The Big Short” had been wrong, their brokerage accounts would have been sold out until those accounts vanished into some fiscal black hole, perhaps leaving them to peddle hot dogs for the rest of their lives at Nathan’s on Coney Island. This is called “getting wiped out.”

Writ somewhat larger than life in this film, the mega-risks undertaken in “The Big Short” are the kind of risks you can take in miniature on in a short sale. Our risks, however, are obviously much, much smaller and (hopefully) much less fraught with danger.

That said, small investors like you and I can still make money (sometimes) by buying or shorting stocks. But, perhaps more than well-heeled investors, we always have to be careful how we do this, while avoiding making the kind of risky bets that would wipe us out, just like the investors and firms on the other side of “The Big Short.”

That’s why we call this column “The Prudent Man.” Over time, anyone who’s prudent and not reckless can make good money in bull markets and not lose too much in bear markets. But for investors who are constantly in search of that big home run… well, you’d better re-think your position before you step into the game.

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Terry Ponick
Biographical Note: Dateline Award-winning music and theater critic for The Connection Newspapers and the Reston-Fairfax Times, Terry was the music critic for the Washington Times print edition (1994-2010) and online Communities (2010-2014). Since 2014, he has been the Business and Entertainment Editor for Communities Digital News (CDN). A former stockbroker and a writer and editor with many interests, he served as editor under contract from the White House Office of Science and Technology Policy (OSTP) and continues to write on science and business topics. He is a graduate of Georgetown University (BA, MA) and the University of South Carolina where he was awarded a Ph.D. in English and American Literature and co-founded one of the earliest Writing Labs in the country. Twitter: @terryp17