Updated: Jul 7, 2021
With all the hype around the GameStop story, many investors have asked us what it means to short sell a stock. We are not going to weigh in with our opinion of what happened or take sides, but simply explain what is involved in a short sale and how risky that investment option is.
When an individual decides to invest in a company's stock, as the company grows the share price rises (since a stock represents an ownership stake in the business). Typically the longer a stock is held, the more profitable the investment is if the company continues to grow.
The flip side of that is if the company fails to grow or loses money, the stock price will fall over time. This is where shorting a stock could give an investor (or as is more often the case, a trader) a profit if timed correctly.
First off, what is shorting a stock?
To short sell a stock, an investor sells a stock in which they do not own. To do so, they borrow the stock through their broker, and therefore must qualify for a margin account (an account that can borrow). In doing this they also have to pay interest on the amount borrowed.
Why would someone sell a stock they do not own and pay interest on the amount borrowed, you might ask? Good question. This is a very risky position, and most retail investors (the average individual investor) should most likely not participate in such a venture.
Why short sell a stock?
The idea is that if a company is going down hill, the stock price generally will follow. So if an investor (or trader) thinks the stock of a certain company is overpriced (due to serious loss of revenue, bad management decisions, not profitable, etc.), they could try to capitalize on the current price before it goes down.
For example, say one short sells 100 shares of XYZ stock at $50 per share. The stock drops to say $25 a share. The investor could then decide to close their position and now actually pay for the stock they already sold, giving them a profit of $2,500 before commission fees and interest of course. Here's how the equation works out, excluding any interest paid while the stock was being shorted:
(sold 100 x $50 a share = $5000) - (buy 100 x $25 a share = $2500) = ($5000 - $2500 = $2500 profit)
Why to not short sell a stock.
Instead of the familiar phrase "buy low/sell high", it's "sell high then buy low". Sounds easy enough, but it's extremely risky!
When someone buys a stock, the risk of loss is only what they bought the stock for, but the potential for gain is unlimited. However, when shorting a stock, the gains are limited to the amount borrowed (basically, maximum gain if shares go to $0, a highly unlikely outcome), but the risk of loss is unlimited because share prices have no cap on how much they can rise.
Let's go back to the previous example. Say someone short sells the same XYZ stock for $50. The most they could gain is the $5000 they sold it for (if the stock goes to $0), minus fees and interest. However, if the price goes up, the investor will eventually have to close the position at a higher amount than what they sold it for.
This amount of loss is unlimited, as a stock could keep going up, all the while paying interest on top of the amount borrowed. For example, say the XYZ stock went from $50 to $250. That would be $20,000 more owed plus interest. If a stock goes up like this, it is hard to know if and when it might ever come back down, forcing the short seller to close their position to cut losses. The longer they wait for it to go back down the more interest they keep paying as well. This is known as a "short squeeze." Many traders that were shorting GameStop had to close their position (by buying what they had borrowed and sold). And a big increase in buyers caused the price to rocket higher. Simple supply and demand, like what you learned in Economics 101.
The bottom line...
Each investor needs to make their own educated decision. Short selling can and has worked for some investors. But it also has ruined investment portfolios. It is more of a short-term venture and should only be done by investors (read traders) who can take such risk. Specifically, those with larger portfolios and available cash that can absorb such sudden and drastic losses.
The much better option for most investors is to buy stocks of companies that they believe in for the long-term. Keep informed with where they are headed and hold the position for as long as you can. Add more to those companies with a proven track record of making money.
If you would like to open up an investment account or get help managing one you already have, please let us know. We can set up a completely transparent account and make the hard decisions for you.