How exactly does short selling work? And what is a short squeeze?

Mar 5 2021, 1:00 pm

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There aren’t many news stories that make people do a double-take these days. But when news broke about a bunch of Redditors making profits of up to $40 million from investing in a bankrupt video game store, no one could believe what they were reading.

How did a bunch of amateur retail investors, some as young as 10 years old, send Wall Street’s elite into financial turmoil, causing some to seek multi-million dollar bailouts? Welcome to the fascinating world of short selling.

So what exactly does the investing technique entail? And more importantly, is it worth the risk? Let’s take a look.

What is short selling?

Just because short selling has been in the spotlight lately, doesn’t mean it’s a new tactic. Some even say what happened in the GameStop saga was long overdue and that the finance community should have seen it coming.

In basic terms, short selling involves counting on a stock price dropping. Traditionally, investors buy stocks that they think will go up in value, also known as investing long. If stocks lose value, investors typically wait until they go back up to sell them for a profit.

On the other hand, short selling allows investors to profit from stocks that have dropped in price, and instead of buying stocks, a short seller borrows them from a broker.

After a certain amount of time, investors have to return the shares to the broker, but in the meantime, they can sell them. The whole strategy behind short selling, and what short-sellers are ultimately banking on, is that the stocks fall in price. This is so they can buy them back for less than they bought them for before. In other words, to make a profit, short-sellers are betting against the stock.

What is a short squeeze?

This might sound like a somewhat safe strategy, if the stock price does what it’s predicted to do. But if a stock goes up in price instead of down, short selling can be incredibly risky for investors. In fact, there is no limit to the price that the stock can go up to, meaning the potential losses are infinite. In the case of GameStop, short-sellers lost a total of nearly $20 billion in January 2021 alone.

And, here’s where it gets interesting. In some instances, if a short-seller’s losses exceed the brokerage firm’s threshold, they can get squeezed out of a position and be forced to buy back shares at market price and/or sell stocks to make up for the loss. This is called a short squeeze.

So, is short selling a good idea?

If all of this sounds incredibly risky (and stressful), you’re not wrong. Short selling isn’t for the faint of heart and is usually reserved for very experienced investors—usually of the hedge fund variety.

Since the risk of losses on a short sale is limitless because the stock price could continue to rise, short-selling really is best left to seasoned traders who fully understand the risks involved.

For all of us regular investors out there, the safer and more recommended way to invest is to hold stocks for a long period of time and avoid unnecessary risks.

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