Betting on failure. It sounds "un-American," doesn’t it? The idea that someone, anyone, can profit from the decline in a stock or the demise of the company speaks to an “immoral” component. That is, if you allow your emotions to think along those lines. For many stock market participants, short selling is all of those things I’ve described. However, for many other cohorts of the market, short selling is also both a wealth-building trading strategy and a way to reduce risk.
The massive stock gains and the subsequent declines we have witnessed in heavily-shorted companies like GameStop (GME), AMC Entertainment (AMC) and BlackBerry (BB), among others, has increased investors’ interest in short selling as an investment strategy. Given the degree of risk in shorting stocks, it is not one that I would recommend to new investors. The strategy should only be used by experienced traders and investors — qualifications which are typically associated with large institutional investors and hedge funds.
How does short selling work?
The investor, trader, speculator (whatever name you wish to use), borrows shares of a company that they believe will lose value over time or by a certain date. Using the borrowed shares, the investor sells the shares to buyers who are willing to pay the current market price. In this case, the strategy is to not only bet that the stock price will fall before the investor has to return the borrowed shares, but the shares will continue to decline. At which point, the investor can then purchase the shares at a lower cost — a practice known as “covering.”
To apply some practical values to the strategy, let's use GameStop as an example. The shares closed up 19% Friday at $63.77 after a gain of $10.27. If a trader didn’t believe that Friday’s gains in GameStop were sustainable and ascribed a fair value of, say $20 to the stock, the trader can short GME stock Monday at $63.77 (assuming it was not higher pre-market). The difference between $63.77 and $20 is $43.77.
Let’s say they expected the decline in price to occur in the next two months, the trader can short (or borrow) 100 shares. The trader, who is now “short” 100 shares, can then sell the 100 shares they borrowed to another investor who perhaps thought GME stock was heading higher and wanted to be “long” the stock. Keep in mind, however, not all stocks can be easily borrowed or are liquid enough or available to loan. In the case of GME, which was already heavily shorted, that was not the case. But for our example, the shares were readily available.
Now, let's say for example, by Friday the GameStop frenzy is starting to fade and the stock falls to $40. The decline yields a difference of $23.77. The trader now has a decision to make. They can either stay in the position (remain short and bet on more declines) or close the short by “covering.” This is where the trader returns the borrowed shares by buying the 100 shares on the open market for at the current rate of $40 per share. In this case, the math works out as follows: Borrowed (shorted) 100 shares at $63.77, minus the current price of $40 leaves a difference of $23.77.
The difference of $23.77 multiplied by the 100 shares that were borrowed comes to $2,377 profit. Subtract any commissions paid and accrued interest on the margin account still leaves a decent gain. But keep in mind, the trade might have worked this time. It might not next time. Why?
The risk of loss on shorting stocks is unlimited from a mathematical standpoint. Again, using the GME stock as an example, it began the year around $17 and skyrocketed $466 higher, or 2700%, in a matter of weeks.
Assuming a trader shorted 100 shares at $17 with the assumption that the stock would, say, fall to $10 -- that short trade translated to a potential loss of $47,000 when it reached $483. Keep in mind, this was with a bet of only $1,700. Not to mention the accrued interest on the margin account the trader would have been liable for.
And it’s for this reason, among others, that short selling — as a strategy — should only be used by experienced investors or portfolio managers who wish to use it as a hedge against long positions. In other words, shorting a stock is more nuanced than just betting on a company’s demise. For example a trader can own Apple (AAPL) and feel confident that Apple will grow profitably for the next 100 years. But if the trader believes that the stock market will correct by 10% in the next six months, the trader may decide — as a hedge — to also short Apple shares during the next six months, thereby profiting on temporary decline.
All told, short selling, despite its villainous undertones, is not a “moral” decision, but one of many investment strategies used to effectively manage risk. That said, the risks associated with shorting a stock (or any asset) is infinitely higher than being on the long side of the trade. But we have seen many examples where short sellers, and the skepticism ascribed to certain companies, have been very lucrative.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Richard Saintvilus
After having spent 20 years in the IT industry serving in various roles from system administration to network engineer, Richard Saintvilus became a finance writer, covering the investor's view on the premise that everyone deserves a level playing field. His background as an engineer with strong analytical skills helps him provide actionable insights to investors. Saintvilus is a Warren Buffett disciple who bases his investment decisions on the quality of a company's management, its growth prospects, return on equity and other metrics, including price-to-earnings ratios. He employs conservative strategies to increase capital, while keeping a watchful eye on macro-economic events to mitigate downside risk. Saintvilus' work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets. You can follow him on Twitter at @Richard_STv.
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