This is about naked short selling, which is illegal. A legal short sell simply mean you borrow a stock from someone, sell it at market value, then wait some short period of time for the price to fall, and then you buy that stock back at the lower price and give it back to whom you borrow it. You keep the profit between when you sold it and when you bought it back at a cheaper price.
Naked shorting is when there actually isn’t a stock borrowed, but someone claims there is. This is fraud, and it happens routinely as the SEC does nothing about it because it involves very large and powerful houses who donate to political parties.
Here is an example of a legal short sell. Short selling is very simple.
1. Person A owns a share of stock.
2. Person B thinks the price of that stock is going to go down.
3. Person B borrows a share of stock from Person A, but only for a defined period of time, say 30 days.
4. Person B also pays Person A a flat fee, say $1, to borrow that stock.
So, Person B has a borrowed share of stock that they have 30 days to return and pay a $1 fee to Person A.
5. Person B then sells that share for say $10 (whatever it is worth on the market at that time).
6. Person B then waits up to 30 days for that stock price to come down from the $10 price they originally paid.
So, Person B has $10 in their pocket, but they must buy a share of stock back within 30 days to give back to Person A. They hope like hell that the stock price is less than the $10 they sold the original stock at.
Two things can happen: Stock price goes down or the stock goes up. Either way, Person B must buy a share to give back to Person A.
Price goes down, say to $6.
7. Person B buys a share of stock at $6.
8. Person B gives Person A their share of stock back, plus the $1 fee.
9. Person B had $10 from originally selling the borrowed share of stock. They paid $6 for another share to return to Person A and they paid Person A the $1 fee. This means Person B kept $3 ($10 - $6 - $1 = $3) for themselves, a nice and tidy profit of $3.
Price goes up, say to $14.
7. At the end of the 30 day period, Person B finds the stock actually went up to, say, $14. They are screwed. They must buy a share of stock at market price of $14 to return to person A.
8. Person B had the original $10 in their pocket from selling the borrowed share of stock, but they must fork out another $4 to have the $14 to buy the share of stock to return to Person A. Plus, there is that $1 fee.
9. Person B must pay out $15 total, and therefore has lost $5 in this transaction.
This shows that shorting a stock can result is significant losses if the stock price goes up and not down. Imagine a $10 stock going to $200! Shorting that stock in this scenario may make up to the $9 for Person B, but it can also result in losses of $191 if the price goes to $200.
Thank you. The eight year old has another question or two.
1. What happens if the naked short seller Person B doesn’t have the $ to actually buy the stock to give back to Person A?
2. What happens if a large number of people do this all at the same time?
3. If a lot of Person B’s do this all at once, can this actually affect the prices of the stock and if so, what direction?
Eight year old thanks you in advance. I know zero about stocks/markets and your explanation was helpful.