Bulls, bears... and pigs
"Bulls make money. Bears make money. Pigs get slaughtered". I've always liked this saying, but I did not always understand its meaning to its full extent. I sure did understand the analogy between animals and types of investors; bulls and bears alike do their due diligence and reap profits during market upswings and downturns respectively, whereas the careless pig invests blindly and gets burned. But I did not entirely grasp the mechanism of making money as a bear. We all know how to make money from a bullish perspective: buy on the cheap, wait it out, and then sell when high enough. But how can you make money when the all indicators fall and the market tanks? The answer is by shorting securities. This is a bear's weapon of choice, and it is essential you understand how to master it if you expect good performance in your investments, regardless of the market's trend.
Being "long" versus being "short"
Let's consider the example of shorting a commodity like gas. You and I are driving our cars. It's been a long drive and we need a refill, so we both pull into the nearest gas station. I tell you that if you fill my gas tank this week, I'll fill yours next week.
Obviously, if you think the price of gas will go up, you'd much rather pay for gas today. In that case you are "long" (or "bullish") on the price of gas as a commodity. You pay $40 now hoping I'll have to pay $50 or more next week. If fate is on your side you'll effectively make money on the arrangement, i.e. getting $50 worth of future gas for $10 cheaper by paying today.
On the other hand, I think the price will go down, so I'd rather delay my actual purchase. I'm "short" (or "bearish") on gas as a commodity. I've promised to buy you something that I don't have yet. I'm betting that I'll only have to pay $30 next week, and that I'll come out ahead on the deal, i.e. getting $40 worth of today's gas for $10 cheaper by paying next week.
As we both now agree on the terms, you start filling my tank for $40 worth of gas, while I give the gas station owner my $30 to seal the deal. You and I shake hands, and plan to touch base next week.
The Consequences of being short
If a full tank is worth $30 or less next week when my purchase is made, I win, and you lose. But if gas climbs up to $55 (i.e. almost twice what I've put down) the gas station owner is going to "call" me on the fact that I've promised to buy a tank of gas. My bet was wrong, so I have to give him the additional $25 to "settle" the "margin" between what I've paid last week when closing the deal and what I owe now.
Let's review this example quickly. When we decided on the terms of the deal, you were bullish and purchased the commodity right away; I was bearish and bought the commodity on a margin. The gas station owner acted as the stock market broker, just like the financial institution you deal with when buying or selling stocks. I've "shorted" gas: I bet its price would go down within a week and I promised to buy a certain amount of it, that the broker recorded (a full tank). If after that week the full tank is worth $55, I have to pay a $25 premium to cover the difference. If that same tank is $20, the broken gives me $10 back.
Are You Ready For Shorting, Part Deux?
Hopefully this shorting analogy using gas as an example was instructional and inspiring. But wait before you put your bear costume on! The last thing you want to do now is rush onto your brokerage account trying to short securities right away. That would be a recipe for disaster. So read on about how shorting actually happens on the market, and learn a few historical facts.
"Slowly but steadily", that's how real bears do it.