To many investors, stocks are a game. By studying, researching, and making the right tactical move at the right time, they believe they can win that game.
That doesn't always mean buying the right stock just before it increases in value. Say you're interested in a company to invest in, but your instinct is that it's going to decline soon. What is your move in this situation?
Certain investors will short-sell that company's stock. It's a move that some use to profit, while others use to try to minimize losses. Other investors, though, think shorting a stock is a bad idea, and something one should never do.
But what does it actually mean to short a stock, and what are the apparent advantages and disadvantages of doing it?
What Does it Mean to Short a Stock?
When an investor goes long on a stock, she buys it with the belief that it is going to increase in value over time. Going short, on the other hand, is what some investors do when they believe the stock is about to decrease and think they can take advantage of that. In short selling a stock, the investor doesn't actually own it.
Let's use an example to demonstrate it. Say you've been reading up on Company X, and you're certain the value is going to go down, and soon. A lot of investors who believe that simply won't touch the stock. A short-seller, though, will act.
Company X shares are currently worth $100 each. The short-seller may borrow 20 shares from their lender or broker, and then sell them. 100 x 20 = $2,000.
Perhaps X's shares fall down to $80. The short-seller buys back the shares and has made a profit. How much? Well, there were 20 shares, and each share declined $20. $20 x 20 shares = a net profit of $400.
That, of course, is the profit made if the short-sale goes how you assumed it would go. It doesn't always. This short-seller might have been wrong, and instead a big week for Company X leads the shares to increase to $110. Now afraid that the shares will continue to rise, the short-seller decides to purchase the shares back before he incurs any more losses. Now, instead of multiplying a profit of $20 by 20 shares, they're multiplying a loss of $10 increase in price by 20 shares they must repay. Their loss is $200.
Short-sellers also have to take margins into account. You don't own stocks when you're short-selling them, so the funds are put into a margin account. The account requires 150% of the short-sale's value to be in it at all times. Because the short sale was worth $2,000, a short-seller would have to put in an additional $1,000 as an initial margin requirement.
That margin will change depending on how the value changes. If the short-seller's instinct was right and the value begins to fall, the total margin requirement will be lower, and a short-seller will receive any additional money from the account.
If the short-seller was wrong and the share value goes up, though, the margin requirement will increase as well, and he will need to put more money into the account.
Why Do People Short-Sell Stocks?
Why do some investors decide to do this? It's clearly a high-risk situation for them, and even more out of their control than a usual investment. Is it worth it?
If they play their cards right, certainly. And what could be more tempting for an experienced investor than the ability to make money off of a company's decline instead of losing money from it? It's not something that would necessarily be part of an investor's overall strategy, but it's something in their back pocket if they're feeling particularly lucky.
Not that individual investors are usually the ones to short-sell stocks. Many short-sellers are hedge funds, trying to protect themselves during a bearish market or worse.
Short-selling is done at times, not just to possibly make a profit, but try to avoid any more disastrous losses. When the market is in a downturn, it can be difficult to find a stock you can profit from while buying. Short-selling a stock gives investors the option to make money in environments where it has become harder to do so.
It is also done to mitigate losses from a declining stock in your portfolio. Say you own shares in a stock that has gone from a value of $150 to $125. You see the writing on the wall and don't anticipate it going back up anytime soon. You could sell it to try to avoid deeper losses. Or, an investor looking to get a little money back could short-sell their shares, and -- if the value continues to decline -- buy them back and perhaps be able to pocket some money from the whole ordeal.
Risks of Short-Selling
There are rewards in short-selling if you get it right. But investors don't always get it right -- and enough of them trying to can have major consequences for an economy.
The pros of shorting a stock are all based on the idea that a short-seller's instinct that a stock is about to tank is a sound, logical one that will come true. Despite your best efforts, however, that isn't something that can ever be predicted with complete accuracy. A lot can happen. What if you short-sell a fledgling company that is suddenly bought out by a larger company and the shares rise? What if a company you view as overvalued doesn't come back down to earth as quickly as you thought it would? Your investment is not only at a loss, but your margin increases too.
If the short-sale has a good buy-stop order, you may be able to protect yourself from greater losses. But if you try to stick it out and the price still won't fall, then you'll be out quite a bit of money.
There's no limit to how much you could lose on an attempted short-sale. Waiting too long to stop a failed short-sale could devastate an investor financially, especially if they made too large an investment in it.
Another thing potential short-sellers need to be aware of: you aren't the only one trying to short a stock. If one investor noticed that a company's shares could decline in value, it's likely a lot of them did. A lot of short-sellers is not good for the market.
Notable Examples of Short-Selling
Some economists put part of the blame for the 2008 stock market crash and Great Recession on all the investors short-selling companies like Fannie Mae and Freddie Mac after the housing market collapsed.
At its worst, too much short-selling may have contributed to major economic problems.
In other instances, it can tell you how investors view a company.
One recent example of a company with a lot of short-sellers is Tesla. As backlash against Elon Musk's tweets about his most recent earnings call grew and he continued to respond to it through tweeting, short-sellers increased.
Musk, to absolutely no one's surprise, has attempted to mock the short-sellers, tweeting the joke, "short shorts coming soon to Tesla merch," but the jokes haven't stopped short-sellers. And who could blame them? In the wake of his tweet about wanting to take Tesla private for $420, the shares have declined by 15%.