A new movie, “The Big Short” is a focused on the Wall Street events leading up to the collapse of Lehman Brothers, which was the first of the dominos to fall in the great financial crisis of 2008. The movie has been nominated for 5 Oscars, is full of beautiful people and is pretty good entertainment too.
It's not up there with the “Wolf of Wall Street” mind you, nor does it have a character as infamous as Gordon “Greed is Good” Gecko, but it's not bad anyway. All these movies have the common themes of unrestrained selfishness, excess and fraud.
The filmmakers know that most of us don't understand the Wall Street jargon, so they interrupt the wheeling and dealing with glossy edutainment spots. Wolf of Wall Street star Margot Robbie appears sipping champagne in a bubble bath to explain subprime mortgages.
While she does a good job, a friend found it quite hard to fully comprehend the concept of a ‘short’ and as a result, couldn’t keep up with the movie.
He asked me to help him understand. So this is what I told him, my “in layman’s terms” explanation of short selling:
In the 1880’s when Karl Benz first drove his horseless carriage, it would have been impossible to predict which manufacturer of this world-changing technology would succeed. In the US alone there have been over 1700 car manufacturers go bust, with only a handful in existence now.
Picking a winner, can sometimes be difficult. In fact, history has shown us that when it came to car manufacturers, it would have been much easier to pick a loser. And herein lies the opportunity for a strategy called “short selling”.
Keeping the car analogy going, imagine you discovered your local car dealership was next week having a 50% off sale for the same model car your neighbour owns.
Is there a way you could profit from this?
If your neighbour is open to lending their car to you for a week, with the promise of course that you’d return it, you could immediately sell it at the current market price (say, $50,000) then use the cash to purchase the same car in the local dealer’s sale (for $25,000). You can then return the new car to your neighbour and pocket the difference as your profit (in this case, $25,000).
Well, you can actually do this with shares and many other financial products.
By borrowing shares and paying the lender interest and the dividends, these shares can be sold (known as “shorting selling”) with the aim to re-purchase them at lower prices at some time in the future, for return to the lender.
Short selling creates profits when prices fall. Short selling is also a gamble.
History has shown that, in general, shares move upward. What this means is that shorting is betting against the overall direction of the market.
So, if the direction is generally upward, keeping a short position open for a long period can become very risky as the losses are infinite. Here’s how.
A short sale loses when a share price rises and a share is (theoretically, at least) not limited in how high it can go.
For example, if you short a share at $30 but the share increases to $90, you end up losing $60. And every dollar that share increases in value, it increases your losses by a dollar, as eventually, you’ll have to repurchase that share at the market price so you can return it to the lender. On the other hand, a share can't go below 0, so the most you can make is $30.
In the movie, they are short selling mortgage products, which is the same concept. To you, it may sound crazy that something has to go down in value to make a profit. But yes, this really happens.
If you can understand this concept, the “Big Short” will make a lot more sense to you.
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IMPORTANT - This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each individual and investor are different and you should not act on this information without speaking to a financial, tax or legal adviser, who can consider if the financial product and strategies are appropriate for you.