Short selling is an expression that comes up often in discussions and news reports about the investment market, and is a popular activity among traders.
It most recently came into the limelight in early 2021, when members of the WallStreetBets subreddit channel started buying stocks whose shares had been sold short in great proportion, triggering a sharp increase in their price and leading to what is called a "short squeeze". As investment ideas spread fast through trading chat rooms and social media, retail investors started chasing the most shorted stocks in the hopes of huge profits, causing turmoil on the market.
But what is short selling exactly, what does it entail? We will explain in detail in this article.
How does short selling work?
A short sale (or 'shorting') is when you sell a stock you borrowed at the current price, in the hope of buying it back later for less money and pocketing the difference. It is the opposite of taking a 'long' position, i.e. buying a stock, in the hope that its price will increase.
In order to do this, you need to have a margin account. The first step in short selling is borrowing a stock from somebody and selling it immediately at the current price. Eventually you will have to buy the stock in order to give it back to the lender and close the positon. So you are hoping that the future price will be lower than the current price because the difference would be your gain.
Who would loan you the stock? Your broker. As this is a loan, your broker will charge you interest. Remember, the stock is not yours, you just borrow it.
You would only short sell a stock if you firmly believe that its price will drop. In this case you hope that you can buy the stock back at that lower price in the future and pocket the difference. As the price of the stock rises, so do the unrealized (or floating) losses on your open position.
Covering a short position means that you buy the stock, thus closing out your position with either a gain or a loss.
Can my broker close my short position? Stocks you short that have a high short interest may be subjected to a buy-in. This means that your broker might close out a part or all of your shorts in a stock by forcing you to buy these stocks at the current market price. Why would they do that? Because in the case of highly shorted stocks, it becomes extremely difficult to borrow the shares, and lenders are demanding them back. This situation tends to occur in stocks that have a less liquid float.
Let's take a look at a few examples!
Shorting one share of Company Short
- Company Short is trading at $50 a share, but you strongly believe that its price will drop soon, maybe because you expect disappointing earnings or you know that the star CEO will leave soon.
- You borrow one share from your broker and the you immediately sell it at the $50 per share market price.
- Company Short’s price drops to $40 per share in line with your expectations.
- You buy the share on the open market for $40 and return it to the lender.
- Your gain is the $10 difference the two prices ($50-$40), minus transaction costs.
What happens if the stock price rises?
- So you have already borrowed the stock at sold it at $50 per share.
- However, Company Short’s price unexpectedly jumps to $70 per share.
- In order to limit your losses, you want to cover your short position so you buy back the share and return it to the lender.
- You suffer a $20 loss ($50-$70), plus commissions and fees.
I hate to break it to you, but although this is a bad outcome, it could be even worse! Let’s see what happens if the stock price doubles. Your loss is $50-$100, or $50, plus transaction costs. And imagine what happens if the price triples? Or quadruples?
As there is no limit to how high a stock can rise, a short seller’s losses are potentially unlimited. In contrast, when taking a long position, that is, when you buy a stock, the worst that can happen is the stock loses all its value, and you lose all the money (but no more than) you invested. Now you know why short selling is such a high-risk strategy!
A sharp price increase in heavily shorted stocks can easily lead to a short squeeze. This is a chain of events where a highly shorted stock’s price skyrockets because many short positions are being liquidated. You can read more about short squeezes in this article.
Now let's see a real life example!
Ailing US electronics retail company GameStop was the first target of Reddit investors in the market frenzy of early 2021 as hedge funds were heavily shorting the stock, betting on its decline. Trading at around $17 per share at the beginning of the year, the stock price skyrocketed during the peak days of the frenzy, reaching as high as around $500 at one point, or nearly 30 times its earlier value.
GameStop was then followed by new targets such as US home goods retailer Bed Bath & Beyond, Finnish telecom group Nokia, movie theater chain AMC Entertainment, and others, whose share prices saw similar spikes.
Retail investors on the hunt for highly-shorted stocks were driving up stock prices, causing market turmoil with short squeezes, trading service outages at some online brokers, and panic among some hedge fund managers. Some hedge funds closed their short positions with heavy losses and many retail traders suffered losses, too.
According to US financial regulators, the core infrastructure of stock and commodity markets was resilient during the high volatility and heavy trading volume.
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