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Short selling: What it is, why it’s risky and how the ‘squeeze’ happens

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Maybe you’ve heard by now that an army of retail investors has managed to use one of hedge funds’ common investment strategies against them.

That is, short-selling. It generally involves selling borrowed shares of a stock with the belief that the price will drop, at which point you’d buy shares at a lower price to repay what you borrowed (more farther below). And it’s not the province of just hedge funds or other large investment entities. Individual investors — for better or worse — can employ it, too, if their brokerage approves it.

“For my clients who want to short stocks, I tell them it’s generally not a good idea,” said certified financial planner Ivory Johnson, founder of Delancey Wealth Management in Washington. 

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Retail investors, led by those in the WallStreetBets Reddit chat room, have been piling into Gamestop, AMC Entertainment and other stocks that hedge funds were counting on going lower.

In a nutshell: All the buying pushed up the prices, meaning the funds’ bets were wrong and they’ve lost billions of dollars. Year to date, for the GameStop short sellers alone, the loss is at least $5 billion, according to S3 Research.

“These investors have access to information, they know which companies are heavily shorted and they’re communicating with each other,” Johnson said. “I wouldn’t be surprised if they keep doing it … it’s like Occupy Wall Street Part 2.”

While this group is demonstrating how retail investors can hit hedge funds where it hurts, the ongoing battle also shows how risky short selling is.

Typically, you buy stocks with the idea that they will rise in price and you’ll make a profit when you sell them.

With short-selling, the end goal is still a profit. Yet the transaction is based on your view that the stock is overvalued, and therefore will drop in price.

The general process: You borrow shares from your brokerage and sell them at the current market price (which, again, you think will fall). Ideally, your view is correct, and when the price has dropped, you buy shares at that lower cost to pay back the ones you borrowed. A simplified illustration: You short a $7 stock. It slides in price, and you buy it at $2. Your profit is $5.

However, if the price goes up, at some point you still would need to finish the transaction — that is, you’d have to buy that stock to repay the brokerage. So if that $7 stock starts rising, and you sell it at $10 to cover your short position, you’ve lost $3.

Some people are going to make a lot of money. But there will be people who … get in and lose their shirt.”

Ivory Johnson

Founder of Delancey Wealth Management

“Most investors think of risk being only on the downside,” said CFP Matt Canine, senior wealth strategist with East Paces Group in Atlanta. “When you buy a stock outright, your losses are finite — if you buy at $100 and it goes to zero, you lost $100.

“But if you short it and it goes to $200, $300, $400 etcetera, your losses are compounded,” Canine said. “The risk on the upside is unlimited.” 

When a stock is heavily shorted, and investors are buying shares — which pushes the price up — short sellers start buying to cover their position and minimize losses as the price keeps rising.

This can create a “short squeeze”: Short sellers keep having to buy the stock, pushing the price up even higher and higher. (This is what happened with the shorted stocks targeted by the Reddit investing crowd). 

Generally speaking, you can only engage in short-selling using a margin account. This essentially is a loan from your brokerage, which will charge you interest and require you to maintain a certain level of funds in that account.

When the value drops below that threshold, your brokerage will require you to replenish the account. Your brokerage also may ask you to cover your short position when the price has gone up.

As for how the saga of Reddit investors vs. hedge funds ends?

“Some people are going to make a lot of money,” said Johnson at Delancey Wealth Management. “But there will be people who … get in and lose their shirt.”

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