Friday, May 25, 2012

Facebook stock is a victim of "Short Selling". What the heck is Short Selling? I give a VERY brief example here using FB stock. This is a strange concept...

Another reason people hate Wall Street is this business of "Short Selling" a stock.  Never have done this and only know about it from what I read.  Here is my barely literate take on how it works... 

You buy 1,000 shares of Facebook stock at the opening price of $38 per share. Your investment in FB stock is $38,000.  However, you don't really possess these shares, your brokerage firm actually "holds" them for you.  

I am a BIG customer of the brokerage firm you used as well.  I believe FB stock is overpriced and the price is going to go down.  I am going to enter an agreement with "our" brokerage firm to borrow your shares of stock (for a fee). Here is what I am going to do:

1.  Borrow your 1,000 shares AND immediately sell those shares (assume the price is still $38 per share).  $38,000 is put INTO my account at the brokerage firm. Your account stays the same and YOU have NO idea of what just transpired between me and our brokerage firm.

2.  As I predicted, the market price for FB stock decreased. Perhaps helped by my borrowing and selling YOUR stock! Assume it drops to $35 per share. 

3. Now you see this on the news, freak out, and want to sell your stock.  This is the fun part.  I am now required, per my agreement with the brokerage firm, to buy those 1,000 shares back at a price of $35 so those shares can be returned to you to sell at $35.  So I have to dip into my account and spend $35,000 to buy the stock.  Remember, as a result of the initial transaction I had $38,000 in the account.  After the subtraction of $35,000 I have $3,000 left in my account.  You originally invested $38,000 and now you have $35,000 as a result of selling at the lower price---$3,000 LESS!!

4. This is the best scenario for me but I do take a risk.  If instead the price of the stock increased, to say $41 per share and you wanted to sell to take your profits, then the situation described above would be reversed---I would have to put  $3,000 into my account to cover the purchase of the stock and you would make $3,000 on your sale of the stock. 

4. The question in your mind has to be: Is this legal? Yes, it is.

Short sellers are betting that price of the stock will go down.  The benefit of allowing short selling is that it tends to keep the price from getting artificially high---or form a "bubble". It serves as a counter-weight to "irrational exuberance" investors might have toward a specific stock.

Bottom line for me:  I see the purpose and value (I think, I do anyway) of short selling, but bothers me that my stock can be traded like this without my explicit knowledge.

If you half-way understood the above, then you are more equipped to read and understand THIS article on the Short-Selling of FB stock in the first couple of trading days.  Pretty interesting read
View My Stats