Short selling: stocks
This is for educational purposes only. Not advice. Speak with an accredited financial advisor before doing any of the following.
We’ve received messages from our Whiskey Hue podcast listeners / Sava360 Newsletter readers regarding various terms they’re hearing in the market. We’re here to educate and inform so let’s take a deeper dive into some of the most recent topics our audience wants to learn more about.
COMMON TERMINOLOGY Let’s first explain investing terms that are commonly confused. Mark to 'market: the current price of a stock on the stock market. Holding a stock ‘Long’ or ‘Short’ means investors bet on, and profit from, a rise in its price. ‘Long’ holding of a stock: a time held characteristic. Holding a stock ‘Long’: an investor holds a stock longer (sells after) than 1 year. Tax ramifications: (15% middle tax brackets, 20% Highest, 0% lowest 2 TBs or <$40K). ‘Short’ holding of a stock: a time held characteristic. Holding a stock ‘Short’: an investor holds a stock for less (sells before) than 1 year Tax ramifications: (Considered normal income, taxed at your current tax bracket).
‘Short Selling’ is different. Short sellers bet on, and profit from, a drop in a its price.
An investor borrows a security and sells it on the open market, planning to buy it back later for less money.
WHAT’S IN A SHORT? As the stock market continues to trend higher despite the ongoing pandemic and economic uncertainty, we take a look at the short selling strategy that some who are less optimistic about a V shaped economic recovery are employing.
So what exactly is short selling and how does it work? Short selling is when you are betting that a certain stock is going to decline in share price whether you believe it to be overvalued or will see some financial hardship that has been overlooked. When you want to bet against a stock, you would essentially borrow shares of the stock and sell it at the current market price and when the stock price declines, you buy the stock back at the lowered price, thereby returning the initial shares to the lender and pocketing the price difference as profit. Please see the example below*.
Seems simple enough right? But what if the stock price goes the other (positive) direction? That’s when it becomes much riskier because when you buy and hold a stock thinking it will rise, your losses are limited to that initial investment. For example, if you buy one share of a $10 stock and then it drops to $0, you lose $10 and that’s the maximum you would be able to lose. When you short a stock, there’s no limit to how much the stock can rise and thus no cap to how much you can potentially lose. The bottom line is: short selling is NOT for the faint of heart.
You might be surprised by the stocks that currently have the highest number of shorts. It is those companies that have seen their stock prices skyrocket recently…yes, even during a global pandemic. We’re talking high profile brands like Tesla (TSLA), Amazon (AMZN), Apple (AAPL), Alibaba (BABA), Microsoft (MSFT), Facebook (FB), Netflix (NFLX), and Google (GOOG) that have shorts that total in the BILLIONS of dollars.
Here’s a snapshot of estimated shorts for these companies:
TSLA: $22B AMZN: $13B APPL: $12B BABA: $10B
MSFT: $9B FB: $7B NFLX: $5B GOOG: $4.6B
THE SHORT SQUEEZE
You may be thinking if you short a stock, you can just hold that short position indefinitely and keep on waiting until the stock price drops low enough for you to rake in a profit or at least minimize your losses when you close out that position. However, unlike buying a stock outright and holding that position potentially forever, when you short a stock, you need to do so in a margin account which requires you to pay interest on the shares you’re ‘borrowing.’ And there in lies another rub…also known as the short squeeze. It’s when a stock price rises so sharply, that short sellers need to buy the shares back quickly in order to not incur any greater losses. When that happens, it only fuels the rising stock price and adds to even more losses for shorts. Because short sellers are typically short term investors, there is added volatility and thus, higher risk all around.
Case in point: TESLA. Tesla’s stock (TSLA) has been on top of the short list for awhile now but with the recent stock price surge to $2,000/share fueled by its 5 for 1 stock split announcement and very likely short squeeze1. TSLA stock is now up 40% since the stock split announcement compared to APPL’s 20% stock price rise since its own stock split announcement. With no other catalyst news out there driving TSLA share price, shorts have reportedly given up over 2 million shares over the last 30 days alone. And with the stock splits that happened Aug 28-31, there may still be more shorts to be squeezed even further.
Short selling can be a very lucrative trading strategy when deployed properly, but nothing is without risk and the volatile structure of short selling makes this strategy a particularly dangerous one so if you’re looking to try it out, make sure you fully understand the risks and volatility involved!
Example 1: ‘SHORTING’ a stock for a PROFIT
A. An investor believes Stock A - currently trading at $100 - will decline in price in the next f few months.
B. The investor ‘borrows’ 100 shares and immediately sells them to another investor on the open market, for the price of $10,000 (100 shares x $100/ea).
C. The investor is now “short” 100 shares since they sold something that they did not own but had borrowed.
D. In their Investing/brokerage account, this shows up as -$10K.
E. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.
F. One month later, the company reports bad earnings for the QUARTER, and the stock falls to $50/share.
G. The investor closes the short position and buys 100 shares on the open market for $50 to replace the borrowed shares and return them to their owner.
H. The investor’s profit on the short sale is $5,000: ($100 - $50 = $50 x 100 shares = $5,000).$10,000 (original sell price)- $5,000 (bought price).
Example 2: 'SHORTING' a stock for a LOSS
A. Same scenario above (A…E), but the stock soars to $65/share. B. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 - $65 = -$15 x 100 shares = $1,500 loss). C. Here, the trader had to buy back the shares at a significantly higher price to cover their position, and lost money. PROS AND CONS OF SHORT SELLING2
A trader who has bought a stock with a traditional ‘buy low, sell high’ strategy can only lose 100% of their money invested if the stock falls to zero. Buy a stock for $100, company goes bankrupt, stocks goes to $0, you’re out $100/share.
With short selling, it’s much riskier because there is no ceiling on how high a stock’s price can go. An investor can lose 3-5x or more of their initial investment. Tesla (TSLA) stock is a perfect example. It hovered around the $175/share range for 18 months, with a lot of investors shorting it (or betting against it). The stock eventually proved many wrong and popped up to $2,000/share (more than 11x higher!). An investor who initiated a short at $175/share and forced to cover at $2,000/share would have lost $1,825/share. Huge loss.
Pros of Shorting: Potential high profits Little initial capital required You can use Leverage Used as Hedge against other holdings
Cons of Shorting: Potentially unlimited losses Margin Account (interest incurred) Short Squeeze ramifications
Prepared with my colleague Ingrid.