children, here’s a story for you to think about:
applecranberry owns a share of apple and the stock price is $600. this is because apple has $100 of cash per share in the bank to cover future r&d and what not as well as all the money it will make from all its cool devices in the future.
applecranberry decides he wants to lend his stock to receive interest on the $600 as apple is not yet paying a dividend - though it has announced it will do some time in the future.
he lends it to orangemango who agrees to not only pay him an interest rate on the $600 value of that share but who also promises to pay applecranberry any dividends that apple might pay during the time the share is lent - whether or not it has been previously announced.
orangemango can now, as the ‘legal’ owner of the share, sell it. and it does so to pineapplecoconut. it does this at the $600 price pinepplecoconut had been offering to pay applemango.
you see, both applemango and pineapplecoconut thought the price should be higher but the latter wasn’t willing to pay it - he wanted to pay $600 only. orangemango thinks they are both crazy. in fact, orangemango thinks the ‘correct’ price should be lower than $600 and will profit if it falls in price and lose if it rises.
the next day, apple announces a surprise $60 dividend payable same day. they say in their statement that now that steve jobs is dead, they’ve run out of cool ideas and are going to spend less on r&d.
straight away the stock prices falls $60. why? because the $600 valuation was based in part on the $100 cash it had in the bank but after paying the dividend it will only have $40 in the bank so the share price falls $60 to compensate for this change.
pinapplecoconut right now looks okay. he owns a share that has a price of $540 but has $60 in cash so he is still worth $600.
and applecranberry thinks he’s okay too - for exactly the same reasons that pineapplecoconut thinks he is happy. after all, they both believe themselves to own the share and they have both received the dividend - one from apple the other from orangemango
orangemango is okay too. he sold the share at $600 and has made $60 in unrealised profit now the share price has fallen to $540. now remember he soldthe share at $600. he invested that money (which is why he is paying applecranberry interest). orangemango simply reduces his investments in treasuries by $60 (thus his unrealised profit is realised) and gives it to applecranberry with that days interest too. so his ‘profit’ has been given away and he is still waiting to see if the stock price will rise or fall in response to the surprise announcement.
so everyone is happy? not quite. the entire panics because they realise that with less spending on r&d apple is going to not make as much profit in the future as they will fail to innovate as much and will rest on their laurels and not come out with a new iSomething each year. and pineapplecoconut panics alongside the rest of them. so he decides he wants to sell. he contacts orangemango and offers to sell the share for $540. orangemango laughs. because everyone else now agrees with orangemango’s pre-existing skepticism of apple’s future growth potential and given the future profits now look a lot smaller then now the price of apple in the market has fallen to $195. pineapplecoconut is so distraught he sells the share back to orangemango at this price. orangemango has to reduce more of his investment to afford to pay for this but having done so, still doesn’t want the share and returns it to applecranberry.
is applecranberry now happy? no. sure he got his $60 dividend. but instead of being worth the $540 it should be or the $660 he thought it should be, the share is only worth $195. (but he’s a believer - he’s done some math and will hold onto this share for life)
is orangemango happy. youbetcha. he also can do math and figures:
- he got $600 when he sold the borrowed share
- all interest he got from investing that $600 he gave to applecranberry so nothing to think about there
- when the share price fell after the dividend was announced, he simply reduced his investment and gave the $60 to applecranberry, so nothing to think about there either
- when the share price fell to $195 and he bought the share back from pineapple coconut, he had to reduce the investment further (it now totals $345) to fund the buyback
- he can give back the share to applecranberry unwinding the loan in the process and have no more liability
of course he is happy, he ends up with $345 in the bank he didn’t have previously
and this children is how dividends get paid to the original owner of the share by the borrower who shorts it. also, all characters in this story are male because as applecranberry says below, girls can’t do math. so what do we say children? do we ask applecranberry whether he can count how much money he has lost? that’s right children: we don’t because he hasn’t told us at what price he bought his share originally. children, i think you are smarter than applecranberry, do you agree?
When you short a stock, you borrow someone’s stock, sell it for cash hoping that the price of that stock will go down so you can buy back that stock at a lower price to pay back the stock you still owe to the person from whom you borrowed the stock in the first place.
But when you borrow a stock, you have to make it look like to the owner of the stock that she still has that stock. So if that company suddenly decides to pay out a surprise dividend, you have to give the original stock holder that dividend out of your own pocket.
Let’s make up an example.
If you borrow a single stock of Apple at $600. You sell it on the open market for $600. Now you have $600. But then Tim Cook says that Apple is paying out a dividend of $60 per stock in a few weeks. Two things will happen. You have give that original stock holder from whom you borrowed that stock $60 because you have to make it look like that stock wasn’t sold in the first place. And the stock price of Apple will go up to $660. Well, not exactly, but pretty close. Because think about it. Yesterday, the stock of Apple was worth $600, but if I wait like two weeks, Apple is going to give me this $60 that no one really suspected was coming. So if I sold my stock for just $600, I would be giving away that $60 for no reason. So I should really sell my stock for $660.
For the guy who decided for whatever retarded reason to short Apple, he is now in the hole for TWICE the dividend. I mean he could wait for the stock to go down to $540. At which point, he’ll break even, but that’s not realistic because the stock would now have to drop $120.
So yeah. That’s the role of dividend payouts in shorts.
And now you know. Girls should learn math. <3 I’ll teach you. For free. :) Because I love you. :)
Apple dividends aren’t that high actually. But it was a nice number to use for the example. O:)
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