I have never sold a stock short. I know you can make money doing it, but the math says you probably won’t, at least not in any consistent fashion. Still, there are any number of hedge funds and institutional investors that spend a great deal of time doing research and putting on short trades as a way to profit from a stock in a downtrend. And they are getting killed recently in a specific short squeeze that is all over the media. So how does that work?
First, let’s think about the mechanics of any stock trade. Unless you are fortunate enough to be buying newly minted IPO shares, when you buy shares of a stock, there is someone on the other side of that trade selling those shares to you. Ideally, they purchased them from someone else at a lower price. This is the essence of buy low, sell high.
A short trade is when you borrow shares from another investor and sell them. You pocket the money and then you have the obligation to buy those shares back later to return them. This works great if the price goes down because you keep the difference. But if the price goes up, you end up with a losing trade. And here is the thing, your potential loss is unlimited. This is the painful math. When you buy a stock in a regular trade, your potential loss is whatever you paid for the stock. If it goes to zero, you would only lose what you paid and it is the inverse on the upside. Technically, there is no limit to how much you can make. Short sales flip that around. The potential return is limited, with the ability to have losses for as long as you can continue to keep the trade on. Everyone has a breaking point.
So, what can we learn from the short squeeze? The squeeze comes when enough buyers make a short trade impossible to bear because the losses are too high and the short seller has to buy back the stock, sometimes at much higher prices. And remember, shorting the stock is betting against the natural tendency of investments to rise. It is what they are intended to do. Short squeezes tend to come en masse even when they’re not organized on social media platforms.
The other thing to learn from this event will become clear at some point. As buyers plow more money into these speculative trades, eventually there will be a point when short traders give up and new buyers will become scarce. And then the price will fall… who knows how far. And if your entire portfolio is in that one stock? Buyer beware.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.