What it’s, why it’s dangerous and the way a “squeeze” occurs
Aimee Dilger | SOPA pictures | LightRocket | Getty Images
You may have heard by now that an army of retail investors have managed to use one of the common investment strategies of hedge funds against them.
That is, short sales. In general, it involves selling borrowed shares of a stock with the assumption that the price will fall. At that point, you would buy shares at a lower price to repay your borrowed shares (below). And it’s not just the province of hedge funds or other big investment companies. Individual investors – good or bad – can use it if their broker approves it.
“This is generally not a good idea for my clients looking to sell stocks,” said certified financial planner Ivory Johnson, founder of Delancey Wealth Management in Washington.
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Retail investors, led by those on WallStreetBets Reddit chat room, have piled up in Gamestop, AMC Entertainment, and other stocks that hedge funds are expecting to decline.
In short, all of the purchases drove prices up, meaning the funds’ bets were wrong and they lost billions of dollars. According to S3 Research, the loss to the GameStop short sellers alone is at least $ 5 billion since the beginning of the year.
“These investors have access to information, they know which companies are severely shorted, and they are communicating with each other,” said Johnson. “I wouldn’t be surprised if you keep doing it … it’s like Occupy Wall Street Part 2.”
While this group demonstrates how retail investors can hit hedge funds where it hurts, the ongoing battle also shows how risky short selling can be.
Typically, you buy stocks with the idea that they will go up in price and you will make a profit if you sell them.
When selling short, the ultimate goal is still a profit. However, the transaction is based on your belief that the stock is overvalued and therefore will fall in price.
The general process: you borrow stocks from your broker and sell them at the current market price (which in turn you believe is going to fall). Ideally, your view is correct, and when the price has fallen, buy shares at that lower cost in order to repay the shares you borrowed. To simplify matters, you are selling a $ 7 share. The price goes down and you buy it for $ 2. Your profit is $ 5.
However, if the price goes up, at some point you would have to finalize the transaction – that is, you would have to buy that stock to pay back the brokerage fee. So if that $ 7 stock goes up and you buy it at $ 10 to cover your short position, you have lost $ 3.
Some people will make a lot of money. But there will be people who … get in and lose their shirt. “
Founder of Delancey Wealth Management
“Most investors think that risk is only down,” said CFP Matt Canine, senior wealth strategist at East Paces Group in Atlanta. “If you buy a stock right now, your losses are limited. If you buy at $ 100 and it goes to zero, you have lost $ 100.
“But if you short it and it goes down to $ 200, $ 300, $ 400, etc., your losses will be compounded,” Canine said. “The upward risk is unlimited.”
When a stock is sharply discounted and investors buy stocks – which drives the price higher – short sellers buy to cover their position and minimize losses if the price continues to rise.
This can lead to a “short squeeze”: Short sellers have to buy the stock over and over, which drives the price higher and higher. (This was what happened to the short stocks that Reddit investors were targeting).
In general, you can only sell short with a margin account. This is essentially a loan from your broker that charges you interest and asks you to hold a certain amount of credit in that account.
If the value falls below this threshold, you will need to replenish the account with your broker. Your broker may also ask you to cover your short position if the price has gone up.
How does the Reddit Investors vs. Hedge Funds saga end?
“Some people will make a lot of money,” said Johnson of Delancey Wealth Management. “But there will be people who … get in and lose their shirt.”