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You may have heard by now that an army of private investors has managed to use one of the usual hedge fund investment strategies against them.
That is, short selling. In general, it involves selling borrowed stock of a stock in the belief that the price will fall, then buying stock at a lower price to pay back what you’ve borrowed (more below). And it’s not just the job of hedge funds or other large investment entities. Individual investors – for better or for worse – can also use it if their brokerage approves it.
“For my clients who want to go short on stocks, I tell them this is generally not a good idea,” said certified financial planner Ivory Johnson, founder of Delancey Wealth Management in Washington.
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Retail investors, led by those in the WallStreetBets Reddit chat room, are piling up on Gamestop, AMC Entertainment, and other stocks that hedge funds reckoned would get lower.
In a nutshell, all the buying pushed prices up, which means the fund’s bets were wrong and they lost billions of dollars. According to S3 Research, the loss since the beginning of the year for GameStop short sellers alone is at least $ 5 billion.
“These investors have access to information, they know which companies are severely short-circuited, and they communicate with each other,” Johnson said. “I wouldn’t be surprised if they keep doing it … it’s like Occupy Wall Street Part 2.”
While this group shows how private investors can hit hedge funds where it hurts, the ongoing battle also shows how risky short selling is.
Most of the time, you buy shares with the idea that they will increase in price and that you will make a profit by selling them.
With short selling, the end goal is still profit. Still, the trade is based on your opinion that the stock is overvalued and will therefore fall in price.
The general process: You borrow shares from your brokerage and sell them at the current market price (which you think will fall again). Ideally, your opinion is correct, and if the price has come down, buy stock at that lower cost to pay back the borrowed. A simplified illustration: you short a share of $ 7. It shifts in price and you buy it for $ 2. Your profit is $ 5.
However, if the price goes up, at some point you’ll still have to complete the trade – that is, buy those shares to pay back the brokerage. So if that $ 7 stock starts to rise, and you sell it for $ 10 to cover your short position, you’ve lost $ 3.
Some people are going to make a lot of money. But there will be people who … get in and lose their shirts. “
Ivory Johnson
Founder of Delancey Wealth Management
“Most investors think the risk is just a downside,” said CFP Matt Canine, senior wealth strategist at East Paces Group in Atlanta. “If you buy a stock directly, your losses are finite – if you buy for $ 100 and it goes to zero, you’ve lost $ 100.
“But if you go short and it goes to $ 200, $ 300, $ 400 and so on, your losses get even bigger,” Canine said. “The risk on the upside is unlimited.”
When a stock is heavily short and investors buy stocks – which drives up the price – short sellers start buying to cover their position and minimize losses as the price continues to rise.
This can cause a “short squeeze”: short sellers always have to buy the shares, causing the price to get higher and higher. (Here’s what happened to the shorted stock that the Reddit investors were targeting).
In general, you can only do short selling with a margin account. This is essentially a loan from your brokerage, which charges you interest and requires you to hold a specified amount in that account.
When the value drops below that threshold, your brokerage will require you to top up the account. Your brokerage may also ask you to hedge your short position when the price has gone up.
As for the end of the saga of Reddit investors versus hedge funds?
“Some people are going to make a lot of money,” says Johnson of Delancey Wealth Management. “But there will be people who … get in and lose their shirts.”