Can you make a profit from falling #stock prices?

That is the billion dollar question most hedge funds or other large #institutional investors are asking especially after a shellshock week in the stock market. The stock causing the most carnage for short sellers is GameStop (GME) which is up over 1,744% since the beginning of the year. Although #GME’s stock price surge is wonderful news for investors who owned the stock to make a profit, it turned out to be a nightmare for those who predicted the stock would fall.

Introducing short #selling – the most misunderstood topic in the realm of investing.

What is short selling?

#Short selling has many names of reference including “shorting” “selling short” or “going short” which basically means the sale of a security or other financial product that a seller has borrowed to make the short sale. In other words, the buyer of a short is betting the price of the financial product will fall compared to the traditional method of investing where you buy a financial product in hopes the price will rise in value.

When short sellers bet a stock will fall, what they effectively do is sell shares they do not have, with the promise of delivering those shares to the buyer at a later date. To sell short, the security must first be borrowed on margin (borrowing to invest) and then sold in the market, to be bought back at a later date.

Example of Short Selling

If an investor thinks that #GameStop is overvalued at $18.50 per share and believes the price will drop, the investor may borrow 100 shares of #GME from their broker, who then sells it for the current market price of $18.50 per share. If the stock goes down to $15.50, the investor could buy the 100 shares back at this price, return the shares to their broker, and net a profit of $300 ($1,850 – $1,550). However, if the price of GME rises to $375 per share, (which happened this week) the #investor would have lost $35,650 ($1,850 – $37,500).

When short sellers bet a stock will fall, what they effectively do is sell shares they do not have, with the promise of delivering those shares to the buyer at a later date. To sell short, the security must first be borrowed on margin (borrowing to invest) and then sold in the market, to be bought back at a later date.

When Shorting Backfires

The problem with short selling is that if the stock goes up instead of down, short sellers must quickly buy the shares they do not actually own to avoid further losses. If many short sellers all think that a given stock will fall, as they thought was the case with GameStop, (which by the way the company has not turned a profit in 3 years) and the stock goes up, mayhem can surface with the urgency to buy the shares. With so many short sellers forced to buy back the stock since they need to return the #borrowed shares back to the broker, the return process ends up increasing the stock price further benefiting the investors who believed the price would go up in the future.

What is this week’s takeaway?

While some may argue that selling short is #unethical because it is a bet against growth, most key influencers in the market now recognize it as an important piece of a liquid and efficient market.

Another way to look at shorting is to keep stock prices honest and within reason. Some may see value in a stock price while others may see things differently. These different opinions are what make a stock market work efficiently.

Have a great day everyone!

Talk soon,

Michael