The first time I watched the Oliver Stone movie Wall Street 2, I was confused about something: Josh Brolin’s company, Churchill Schwartz, makes a ton of money when the company that Shia LaBeouf works for, Kellar Zabel (KZI), starts to dramatically fall in stock price.
Contrary to conventional investing, how is it that someone gets “rich” from stock prices going down?
How Shorting a Stock Works:
Although there were a lot of factors at play in the movie, the basic answer to this question is that Schwartz was “shorting” the Kellar Zabel stock. What does that mean? Let’s look at a simple example:
1. You believe company KZI will not do very well in the near future. This may be due to a trend you have observed, a new CEO that you lack faith in, your gut feeling, etc. When you have faith in a company, you go “long” on a stock. In this situation where you lack faith, you decide to “short” the stock.
2. You enter into an arrangement with a broker to sell a set amount of shares at the current market price. For example, let’s say we sell 1,000 shares at $100 = $100,000 total.
3. As part of the short-sale, there is a contractual amount of time you must pay back the broker the number of shares they sold on your behalf.
4. A short-time passes and your hunch was correct. Company KZI goes down to $25 per share. You pay back your broker back the 1,000 shares at $50 each for a total of $25,000.
5. Congratulations! You just made $75,000 (minus fees and taxes of course).
Gambling on the Future:
Sounds great, but is there a catch? You bet!
Had the price gone up to $300 per share, guess what? You’d be stuck buying back the shares for $300,000. In other words, you’d lose $200,000. Ouch!
Basically, unless you can see into the future or know something the rest of don’t, shorting a stock is very similar to gambling because your speculating on what may or may not happen. Many experts argue that this is different from traditional investing because most of us want companies to do well and see stock prices rise. Just like with any complicated investment technique, you should never use any strategy where you don’t fully understand everything involved.
Although the movie Wall Street 2 is fictional, it is based on real events that happened throughout the Great Recession in the late 2000’s. Kellar Zabel is supposed to represent the investment firm Bear Sterns which collapsed in 2008 and was bought by JP Morgan Chase. Churchill Scwartz is a mixture of Goldman Sachs and JPMorgan Chase. The movie also has images of kids “blowing bubbles” (Get it? If not, click here.) and a shot of the building where Bernie Madoff committed his Ponzi scheme.
Have you ever thought about participating in shorting a stock? What kind of role do these play in your investment portfolio?
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