By: Joseph Goldy, AAMS®
Recent market moves in stocks of companies such as GameStop, Bed Bath and Beyond, AMC, and others have prompted a lot of discussion around the practice of shorting stock or betting a stock’s price will fall rather than go up.
What is Short Selling?
While short selling is credited to the Dutch in the early 1600s, shorting stock in the United States began around the 1820s. Jacob Little, who was known as “The Great Bear of Wall Street,” amassed a fortune by making bearish bets on the New York Stock Exchange, eventually becoming one of the richest men in America at the time. However, like certain hedge funds of today, Little learned the hard way that “What goes down must go...up?” and wound up dying broke after his luck shorting stocks ultimately ran out.
When you short a stock, you borrow another investor’s shares (who never knows you’re borrowing them) and then sell those borrowed shares first, which locks in your sell price. You do this because you feel the stock’s price will decline in the future, and at that time, you will “buy to cover,” whereby you are returning the shares you borrowed and locking in your purchase price, hopefully at less than your sell price, the difference is then your profit.
Example of Short Selling
Jack feels strongly shares of XYZ, which are trading at $25 a share, will decline in value in the coming months. Jack first completes a margin agreement with his brokerage firm since having a margin account is necessary to short a stock. (Incidentally, when signing a margin agreement, you agree to lend your shares out. You can always do what you like with your shares regardless of them being lent out or not, but you should understand what is in the agreement between you and the brokerage firm.)
After Jack completes a margin agreement, he enters a sell short order at $25. His brokerage firm then will locate another margin client at the firm that also owns XYZ shares and is also borrowing on margin. You cannot borrow someone else’s shares if that other person is not borrowing money from the brokerage firm, known as carrying a debit balance. Jack’s brokerage firm finds Jill, who owns XYZ and maintains a debit balance, so Jack’s trade goes through, and he is now short XYZ at $25.
One of two things can now happen, XYZ either goes up or down. Let’s say the stock falls to $20 a share; Jack can “buy to cover” his short position (returning Jill’s shares to her), and the $5 difference between what he sold for ($25) and where he repurchased the shares ($20) is his profit. If the stock goes up, he will have a loss as it increases since he will eventually need to buy to cover at some point.
What is a Short Squeeze?
However, when a short squeeze occurs, it can cause a rapid, albeit often temporary, rise in a stock’s price, as with GameStop. The short squeeze phenomenon happens when a stock begins to move higher, driven either by good news, a positive earnings report, or as in the case of GameStop, retail investors collectively banding together to drive up the price of the stock. Short sellers begin to get nervous as they watch the stock’s price rising and their paper losses mounting, and eventually, when they cannot stomach the pain any longer, they too start buying to cover their short positions, which drives up the price of the stock even further (as of the day of this writing, GameStop shares had a low of $112.25 and a high of $483.00)
Although it may be tempting to try and profit from a company’s share price decline, it is critical to fully understand some of the risks inherent in this strategy and how to protect yourself.
For example, if you are short a stock, you could be subject to a forced buyback where you are required to close out your short position, usually at an inopportune time, regardless of wanting to or not. Forced buybacks happen when the person you borrowed the shares from decides to sell the stock you were borrowing, and the brokerage firm is then unable to find another client to borrow shares from.
Other Things to Know About Shorting Stock
Shorting a Dividend Paying Stock
Something else to be aware of is if the stock you shorted pays dividends, you are obligated to “pay” those dividends to the person you’re borrowing the stock from (Jill in our example).
What is a Margin Call?
Additionally, since you are using a margin account, if you borrow from your brokerage firm, a short stock going up in value can cause you to incur margin calls if it rises enough. A margin call could require you to close out some of your positions even if you don’t want to. If the stock increases rapidly enough in extreme cases, your brokerage firm will close out your position without notifying you first.
What is a Stop-loss Order?
To mitigate this risk, you can protect yourself by placing a buy stop-loss order above the price you shorted at, which could limit your losses if there is an unexpected quick move upward in the stock. Additionally, hedging a short position with a long call option on the underlying stock is another technique to protect yourself. This strategy will effectively lock in the price you can buy to cover for a certain period, allowing you to know your loss amount if the stock moves against you.
While not everyone agrees, many believe the ability to short stock provides a necessary function in the market to allow investors and speculators the opportunity to capitalize on a stock’s price getting ahead of itself and rising too quickly. Short selling forces a stock’s price back to where the collective market believes it should be, based on earnings and the company’s prospects. Having some guardrails in place to minimize market manipulation makes sense, of course, but only if those rules apply to both institutional and retail investors.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.