The Lazy Economist: What you need to know about stock shorting

Why it's the opposite of regular investing

Shorting stocks was at the center of the Great Recession of 2008.

If all you took away from the movie The Big Short was an image of Margot Robbie in a bathtub, you're not alone.

Although the film did a great job of breaking down the Great Recession of 2008, it can still be hard to understand the complexities of that financial crisis. At the centre of it, there's the concept of shorting—specifically in the housing market.

You don't need to understand the recession or even the housing bubble to get a grasp of shorting.

Shorting, in its simplest terms, means betting against the market. Like regular investors, short sellers work with financial securities, often in the form of stocks. 

In the game of investing, the golden rule is to buy low, sell high. Buy your stocks for a low price and sell them when the value of the share goes up—this can be over the course of a day or even years.

In the game of investing, the golden rule is to buy low, sell high

Regular investors will buy at a lower price in hopes the stock’s value will increase. If it does, they can then sell their stock at a higher rate to make a greater return. The profit is the difference between the prices they bought the stock and what they sold it at.

The same rule applies for shorting, but in the opposite way: sell high, buy low. It's for this reason shorting is called “betting against the market”—you bet that your stock will drop in value, not go up.

A short seller will borrow stocks from a financial broker, like an asset manager. They’ll then sell these borrowed stocks at their current market price and keep the remaining income.

Next, they return the borrowed stocks to the broker they borrowed from. If all goes according to plan—the stock tanks and drops in value—the short seller will wait and buy back the same stocks at a newer and decreased price to return them.  

Their profit is how much they sold the shares for originally minus the cost to buy them back.

A good time to ‘short’ would be when a seller can predict a company will depreciate in value. A short seller's dream is to catch a company they're betting against right before it goes bankrupt. The stocks cost can be bought back for next to nothing.

If we tie this information back into The Big Short, hopefully it now makes sense why Christian Bale, Steve Carell, Ryan Gosling, and Brad Pitt chose to short the housing market—they saw the swift downfall of an inflated market as their shot, and they took it.

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