Wednesday Q&A – The Long and the Short of it

Hey man
Hey.

Quick question
Shoot.

You know all that nonsense you were talking about with GetSwift last week?
As in how they were “allegedly” misleading investors by releasing “allegedly” false or misleading details about some material contract wins, which may or may not have over represented how profitable their business was and potentially led investors to buy shares in the company they otherwise may or may not have?

Yeah. That nonsense. So after this “alleged” “unconfirmed” “fraud” came out last week, the stock price fell over 75%. Apparently a number of hedge funds made a truck load of money from this. How is that possible? I mean, the stock FELL. How did they make money?
It’s a great question. They went “short” GetSwift stock and it works like this.

As you know, if you have a positive outlook on a company, you buy its shares in the hope you will be able to sell them at a later date at a higher price. On day one you pay cash and receive shares and at some point in the future you will sell your shares and receive cash back. The difference between what you paid initially and what you received at the end is your profit (or loss).  That’s investing 101.

In investing parlance, when you buy something they say you are “long” it. So if you want to sound like a knob, if you own a car, you can say you’re “long automobiles”. And if you own a house that you’re “long housing”. But if you’re not, just say you own a house and car.

You haven’t actually answered my question yet.
I know. I’m working up to it. Say instead you had a negative view on a company and you thought that its share price was actually going to be lower in the future rather than higher. What do you? Well, if you owned the stock already, the simple answer is you would sell it. But what if you didn’t own it? What if you didn’t own it, but were convinced the stock price was going down? How could you make money? Well then we move into the more murky world of hedge funds and the concept of going “short”.

Still haven’t answered it…
Well maybe if you stopped interrupting me I would.

I’m sorry. I hate it when we fight.
Me too. Let’s never fight again.

K x
So, going short works in the exact opposite way to how “going long” works. When you go short, you sell shares today in the hope you will be able to buy them back at a later date at a lower price. On day one you sell shares and receive cash and then at some point in the future you will buy the shares back and pay cash. The difference between what you initially received for selling the shares and what you had to pay in the end to buy them back is your profit (or loss).

But how do you do that if you don’t actually own the shares in the first place?
You borrow them. You borrow them off someone who already owns them under a promise to give them back to them at a later date. Importantly you are borrowing the stock from them, you are not buying the stock from them.

It’s getting complicated. Step me through it please.
It’s a bit like borrowing a DVD from a video store (remember what they are?). The video store still owns the DVD even while you’re using it at home. You’re just paying them a fee to borrow it. At some point in the future though you are obligated to return it to them.

For hedge funds who go short, it works the same way. They find a current owner of the stock and enter into an agreement to borrow (or rent) it from them, paying the original owner a ‘rental fee’ in return. They then take this stock and sell it (“short it”) and hope they will be able to buy it back at a cheaper price before they have to return it back to the original owner.

That’s exactly what a few, very successful hedge funds did with GetSwift. And boy did they make a lot money.

Anyway, that’s 5 minutes. Hope it helped.



Categories: Investing, Macro Economics

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: