A follower on my Twitter account asked me a simple question this week, “Kalu how can I short Dangote Cement?”
First, what does shorting a stock mean?
Shorting is seeking to profit from the projected fall in the price of an asset. It involves borrowing shares you do not own and then selling to another investor. The strategy is selling high and buying low, i.e. selling the stock today, generating cash today with the intent to repurchase the same stock at a lower cost, making a spread.
To be able to short any stock, you need.
- A research-based belief that the asset is overpriced, i.e. it is trading in the public market at a price above its intrinsic value.
- Availability of shares that can be borrowed, sold, and rebought. This implies that the target stock to be shorted should have sufficient volume.
First, let us understand the terms I will use?
If I am selling, I am Shorting or Putting.
If I am buying, I am going Long or Calling.
So how do I short a stock?
I have identified the target stock to short, let us call it Kalu Plc or KPLC. Let us assume the stock is priced today at N100.00. I go to a broker that holds stock of KPLC, and I borrow 10,000 units of PLC for three months. He will charge a fee for this. Let us assume the fee is 100.00 per 10,000 shares for the 90 days. I will simply sell those shares of KPLC for 100 per share and bank 1,000,000.
So, my position is cash N1,000,000 liability N1,000,000 (10,000 shares of KPLC)
Next, I can buy a Forward Call to cover my bet. This means I buy an option to buy KPLC at 100 in three months as well. The is called a Hedge. I am covering my Short position on PLC by buying the option to buy KPLC back at N100 in 90 days, I will also pay a fee to buy this cover. This means if KPLC instead of falling, rises in value, I will not make money, but I also will not lose money because my Put (Sale) trade has been covered by my Call (Buy) trade. This is called a Covered Call.
Can I Short without a cover?
Yes, I can still Short KPLC without buying a call option. That will save me the expense of paying the Call premium and increase my overall projected profit but expose my trade to unlimited losses if the shares of KPLC do not fall but rise.
What happens if shares of KPLC fall as planned?
If shares of KPLC fall, that is perfect. Let us assume shares fall to 50 per share in 90 days, I simply debit my cash position for 500,000 and buy back the 10,000 shares of KPLC and return to the broker I borrowed it from. I have just made 500,000 or 50% (ignoring fees).
What happens if shares of KPLC rises?
If shares of KPLC rise instead of falling, problem. Let us say KPLC goes from 100 to 150 in 90 days, this means I must spend 1,500,000 to buy back the initial 10,000 shares a return to the Broker, I have lost 50%.
What if I covered my Short call?
Well, if I covered by Short Putting by buying the 90-day Call, then that was smart. I can simply exercise that call to buy 10,000 shares at 100 instead of 150. This means I debit my cash account to fund my Call excise and repay the broker. I do not make any return, but I do not lose N500,000.
What about options?
Now I can increase my potential returns (or magnify my losses) by simply buying options.
Options are exactly what is described above both in Call and Put scenarios, but options are sold in units of 100. Thus the 10,000 units are 100 options contracts. Leverage allows the investor to make money on the upside but magnify losses on the downside.
So back to Dangote…
Can I short Dangote Cement? The simple answer is yes, rules exist to enable a short of Dangote Cement, the real question is can you make money from that trade?