Stock shorting is popular among public investors, however, it is not applicable in all types of company stocks. Only individuals dealing with public company stock can short shares. Private company stock cannot be shortened regardless of the number of willing stock buyers. To perfectly understand why it can’t be done, it’s vital to first comprehensively define what shorting entails
What shorting entails
To effectively generate money from shorting, you have to be good in market speculating and analysis. As an investor, you have to concentrate on the particular stocks you think are currently overpriced and will possibly depreciate later. Selling such stocks in the current market and buying them later at a lower price earns you some significant profit especially if the price margin is quite large.
You definitely need to have stock to sell it. Unfortunately, you may not have the particular ‘overpriced’ stocks. The best way to acquire the stocks is to borrow them from a share holder. You can do this by directly contacting the holder or using your broker. Some brokers usually ‘borrow’ stocks from unknowing holders and lend them to investors for shorting. Such stocks always have to be returned immediately after the shorting before the holders realize they are missing.
As an investor, you will short by selling the ‘overpriced’ stocks and waiting for the price to subsequently depreciate. When the value significantly reduces, you should buy the same number of stocks and return them to the lender. You will therefore end up pocketing the profits that the stocks have acquired. Although this is a relatively attractive business endeavor, it is considerably risky since company stock may appreciate instead of depreciating. Let’s now take a look at a numeric example.
Let’s say I own 10 shares of company ABC at $10 per share. You believe the stock price of ABC is overvalued and is going to crash sometime soon. You then come to me, and ask to borrow my ten shares of ABC and sell them at the current market price for $10. I agree to lend you my shares as long as you pay me back ten shares of ABC at some point in the future. You take the ten borrowed shares, sell them for $100 and pocket the money (10 shares x $10 per share = $100).
The following week, the price of ABC stock falls to $5 per share. You call your broker and tell him to buy 10 shares of ABC stock, at the new price of $5 per share. You pay him the $50 (10 shares x $5 per share = $50). You then return the shares of ABC that you borrowed from me.
In summary, you borrowed my shares of ABC, sold them for $100. When ABC fell to $5 per share, you repurchased those ten shares for $50 and gave them back to me. This resulted in a $50 profit for you (minus of course any trading fees).
What would have happened if you were wrong and the stock price had increased? You would have had to buy back the shares at the new, higher price, and absorb the loss. Unlike regular investing where your losses are limited to the amount of capital you invest (e.g., if you invest $100, you cannot lose more than the $100), shorting stock has no limit to the amount you might ultimately lose. In the unlikely event the stock had shot up to $500, you would have had to purchase ten shares at $500 a share for $5,000. Taking into account the $100 you received from selling the shares earlier, you would have lost $4,900 on a $100 investment.
Public vs Private Company Shorting
Public company shorting is possible primarily because stocks can be freely sold. They can be easily sold to willing buyers and re-acquired through willing sellers. However, the transfer of private company stock, is limited due to the current restrictions on private company stock and thus cannot be freely bought or sold.