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