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Short-selling

Lesson in Course: Stocks (beginner, 8min)

We've heard of the movie "The Big Short." What is short-selling and does it apply to us?

Eureka!

What it's about: Some investors will borrow stocks to sell at a high price with the hope of buying them back at a lower price.

Why it's important: Short-selling is speculative and extremely risky.

Key takeaway: We're better off buying a put option rather than short-selling if we think a stock price is going to fall.

Short-selling is traditionally used by Wallstreet and professional investors to bet against a stock or company. Short-selling, aka "going short", is the opposite of buying shares, or "going long." 

What is Short-selling ?

When investors bet against a stock by borrowing shares of a company from their brokerages to sell it right away. The short-seller will eventually buy back the shares to return them, hopefully at a lower price.

Buying has an unlimited upside since there is no ceiling to the share price and a limited downside since the lowest price a share can drop to is $0. As opposites, shorts have an unlimited downside and a limited upside — this inverse payoff structure is what makes short-selling inherently riskier.

 

How does it work?

Investors short-sell a stock by paying their brokerage a fee to borrow shares and sell the shares at the current market price. They then need to return the borrowed stock at some point and will make a profit if the price is lower when they buy it back. 

Example of short-selling

Here's an example of how Melvin Capital, a hedge-fund famous for heavily betting against GME, would go about shorting $GME. 

  1. The firm would go to a broker and borrow 100,000 shares of $GME at $35 per share and sell it right away for a cash gain of $3.5 million. 
  2. If $GME ends up dropping down to $8 a share, then the fund only needs to spend $800,000 to buy back the 100,000 shares — bagging a profit of $2,700,000 minus what the brokerage charges to lend the shares. 
  3. Alternatively, if $GME reached $100 per share, Melvin would have to buy 100,000 shares back for $10,000,000, resulting in a loss of $7,300,000. 
 
What is Short interest?

Represents the number of shares that have been sold short and can be seen as an indication of market sentiment about a company's stock

GME's short interest

GME's short interest had reached 140% at one point during the meme stock bubble. How can GME’s short interest be over 100%? Let's assume the broker lends 100 shares of GME to Hedge-fund1. HF1 shorts and sells those shares. The broker can then lend 40 of those same shares to HF2, which also decides to short GME. In this case, the original 100 shares created a short position of -140 shares.

 

Short squeeze

Investors have to use margin accounts to short stock. If the price of a shorted stock rises, those who bet against it will start to see losses. They will end up cutting their losses by covering their shorts, which means they need to buy back the shares to return to the broker. 

Investors rush to cover short positions in a squeeze

When the investors can’t meet margin requirements or the stock price rises too rapidly, the brokerage can automatically cover short positions. This is usually forced when the risk of mounting losses is unmanageable. The forced buying from covering shorts continues to raise the stock price which increases the losses for other short-sellers and the cycle continues. This feedback loop causes a short-term spike in the stock price.

Check out this video for more details about the GameStop short squeeze
https://www.youtube.com/watch?v=ZoPEaBAe0CY
 

Actionable ideas

It's incredibly expensive and risky to short stocks and it’s to be avoided. Instead, you should buy put options if you want to speculate on a stock price going down.

Supplemental materials

Here's a short video reviewing the basics of short-selling
https://www.youtube.com/watch?v=Z1LctxzEREE&t=2s&ab_channel=WallStreetSurvivor

Glossary

What is Short-selling ?

Short-selling is when investors bet against a stock by borrowing shares of the company from their brokerages and sell it right away. The short-seller will then eventually buy back the shares to return, hopefully at a lower price.

What is Short interest?

Represents the number of shares that have been sold short and can be seen as an indication of market sentiment about a company's stock