Short Selling? Don’t Get Squeezed

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by Advice Chaser
by Advice Chaser

What comes up, must come down. Occasional market drops are inevitable in our economy. The general advice is to sit tight, leave your investments alone, and wait for them to recover. This is an excellent strategy that will keep you from losing much money. However, you may have heard professional investors can make a fortune on other people’s bad luck by short selling. What is this strategy, and how can a person short sell with a minimum of risk?

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Short Positions

In investing, a long position is one where you make money if the value of an investment goes up. You are betting that it will do well. A short position is one where you make money if the value decreases—you bet against that stock.

There are several kinds of investments where you can take a short position. For instance, you could purchase a put option, or enter a futures contract on the selling side. In both of these cases, if the underlying commodity or stock declines in value, you will make money. Short selling is another type of short position. In this case, you borrow stocks from an investment bank, sell them, and then buy them later to return them to the bank. 

Let’s understand this with a concrete analogy. Say it is the week before Halloween, and you want to make money selling candy. A store will let you borrow some candy for two weeks, for a fee of $10. Candy is in high demand right now, so you sell the candy you borrowed for $100. But now you don’t have the candy you borrowed. You wait until Halloween is over, when the price of candy predictably drops, and rush out to buy candy on clearance for $20. You give the candy back to the store, walking away with a profit of $70.

If you think that sounds like a bad deal for the store, you’re right! They can predict the change in the price of candy just like you can. Unlike with candy, nobody knows for sure when the prices of stocks will rise and fall. If you are better than other people at guessing the direction a stock will take, you can make money. If not, someone else will make money off of you.

How to Short Sell

Short sales always take place with the intermediary of an investment bank or other financial institution. They will lend you the stocks you want, for a fee. You will pay a percentage of their value, as well as assorted fees. To participate, you need a margin account with a brokerage. This ensures you will be able to cover the costs that may arise. In some cases, you will need to deposit as much as 150% of the expected value, in case the stock price goes up and you have to buy it at a higher price.

You can then sell the stock at the moment you think the market is highest. Then, when the stock value has fallen and you think it’s near the bottom, you buy it again.

Short selling is risky because in the very best scenario, the stock price drops to $0. The most you can ever make is the amount you were previously able to sell the stocks for. However, the stock price can go up indefinitely. If you were very wrong about the value of the stock, you may end up paying many times what you originally invested.

Short Squeeze

If the stock price goes up, your bank will require you to deposit more money in your margin account to cover the cost. At some point, you will not be able to keep depositing more. When that happens, you have to buy the stock at the current high price—you can no longer afford to keep waiting for it to peak. As many short-selling investors are forced to do the same thing, the price of the stock continues to rise. This is called a short squeeze.

A famous short squeeze happened in early 2021 with GameStop stock. The stock looked like it would surely drop but, thanks to a number of Reddit investors buying it, it unexpectedly went up. This was so unforeseen that many hedge fund managers were forced to buy the stock at a high price. That forced the price even higher, with the result that the Reddit investors made money while the hedge fund managers lost huge amounts. Remember, you can always lose more on a short position than you can gain.

So, does that mean you should instead buy large quantities of the stocks other people are shorting? No, because they are shorting it for a reason. It looks like it will very likely fall. If so, you will lose your investment. Still, when simply buying stocks, your losses will only equal what you put in in the first place. It’s a less risky strategy than short selling, but a better bet still is to buy stocks, funds, or bonds that are doing well. Short selling is a type of hedge, with a chance of decreasing your losses in a bear market. As such, it should be a small portion of your portfolio.

Get Professional Advice

As you can see, both the risks and rewards of a strategy like short selling can be large. At best, you can make money to counteract losses elsewhere in your portfolio if the market takes a dip. But at worst, you can lose a large amount of money. These are not decisions to make alone, even as an advanced investor. You need a financial advisor to help you read current market trends and build a stable portfolio. To connect with the right person for you, contact us today.

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