What Does Shorting a Stock Mean?

What Does Shorting a Stock Mean?

It was just about a year ago when a company that most of us had completely forgotten about began trending on Twitter and making headlines. GameStop, which sold video games, video-game consoles and accessories, video-game merchandise, and consumer electronics, was once a highly successful retailer. Around 2016, however, its sales began to decline and then plummet. The popularity of both online shopping and online gaming caused customers to leave the brick-and-mortar GameStop stores in droves. (You could say they put the “stop” in GameStop.)

So why did this near-obsolete chain suddenly reclaim the public’s attention in early 2021? It has a lot to do with the online discussion-forum portal, Reddit, and an investment strategy called shorting a stock.

What Does Shorting a Stock Refer To?

Shorting a stock, also referred to as short selling, is a complicated strategy. In simple terms, it refers to the practice of borrowing shares or securities, then immediately turning around and selling them. The investor who shorts a stock is speculating on its price, taking a calculated risk that the stock’s value will drop. After borrowing the shares, then selling them to another investor who’s willing to pay market value for them, the would-be short seller waits for the per-share price to drop. Then they snap the stock back up again and return it to the original owner they first borrowed it from — making a tidy profit in the process.

In other words, shorting is exactly the opposite of the traditional Wall Street mantra of “buy low, sell high.” That’s what investors who choose a “long” approach are doing, and one key element in that tactic is the desire and ability to both purchase the stock and then hold onto it, riding out the ups and downs of the market.

Short Selling a Stock Is Risky but Potentially Rewarding

There are, of course, pros and cons to any investment strategy. What potential pitfalls are there to shorting a stock?

Short selling hinges on the ability to borrow stocks, as well as on the bet that the stock’s value will decline. Since the investor is essentially selling the stock before buying it, there’s a fair amount of risk. There is limited potential for gains since a stock can only drop down to $0. On the other hand, an investor could make a poor prediction about the stock’s performance. Sometimes a stock will surprise even the savviest trader, and its value will start to climb. Theoretically, there’s no upper limit to the price — and therefore no upper limit to the short seller’s loss. Should the cost exceed the amount the investor sold their borrowed stock for, they have only two options: wait out the market or buy the security back and return it to the lender.

The latter choice requires you to make up the price difference since the shares were worth less at the time they were borrowed than they are upon return. Waiting out the market isn’t a great option either; after all, the whole process depends on a relatively quick turnaround, which minimizes your risk. If the company pays dividends while you are shorting the stock, you will owe that dividend to your lender. The fact that you don’t own the stock you’re using to speculate can put you between the proverbial rock and hard place.

Looking at an Example

Let’s say that you’ve been keeping an eye on a widget company. Let’s call it Widgetopia. You’ve heard rumblings about some unsavory behavior on the part of Widgetopia’s CEO, and employees seem to be jumping ship at every turn. Additionally, sales at the big-box retailer’s stores have been flagging, especially since its main competitor, Widgets Online, has practically revolutionized the way widgets are manufactured and shipped. Widgetopia simply can’t match Widgets Online’s rock-bottom prices and, as a result, is closing more and more of its locations.

So you call your broker one day and discuss short selling some Widgetopia stock. She locates 100 shares, loans them to you, and then finds a buyer for them, at a market value of $20 per share for a total of $2,000. And just as you suspected, it’s not long before Widgetopia goes belly-up. Stock prices drop to a mere $5 per share. You immediately buy back those 100 shares you borrowed for only one-quarter of their selling price. After returning the stock shares (and paying a couple of relatively small fees for the privilege of borrowing them), you walk away from the deal with a tidy profit of $1,500.

But what happens if you’re wrong? Maybe Widgetopia releases a revolutionary new product: the Widgetron 3,000, a widget to end all widgets. Overnight, the stock soars. While you’re sleeping, snug in your bed, Widgetopia’s share price zips right past that benchmark of $20 and lands at $50 per share. When you awaken the next day, those 100 shares of stock you sold for $2,000 are now worth $5,000. Now, not only are you out the original $2,000, but you’ll also be obliged to pay another $3K to repurchase those shares in order to return them.

Reddit’s Role in the GameStop Debacle

GameStop stock became the focus of some short sellers after the beleaguered company brought onboard three executives from pet subscription-box juggernaut Chewy. In fact, the price of GameStop’s stock had already doubled by the time it captured the attention of the Redditors, who were members of a group called r/WallStreetBets. They noticed that a number of large hedge fund investment firms, including one in particular called Melvin Capital, had taken a substantial short position with GameStop securities.

In a move reminiscent of a latter-day Robin Hood, the Redditors conspired to drive up GameStop’s value on Wall Street — to increase the losses incurred by the institutional investors, the hedge fund execs they considered to be greedy, immoral, corporate “fat cats.”

This, in turn, led to a damaging downward — or, really, upward — spiral. As the hedge funds started buying back the shares as a stopgap measure intended to limit their losses, the price ticked upward in response. In the end, rather than snapping up those falling stocks to make a profit, the hedge fund investors who’d been so bearish on GameStop ended up scrambling to buy and return them, in a fruitless attempt at cutting their losses. This scenario is known as a “short squeeze.”

Is Shorting Bad?

It’s certainly true that short selling a stock is controversial. But is it actually immoral? Dangerous? Just an all-around bad practice? Well, there are compelling arguments on both sides.

Short selling can contribute to market declines. Critics say that the bet against a particular company can turn into a self-fulfilling prophecy. They also say that it’s morally wrong to profit off of someone else’s misery; those who use a shorting strategy, after all, are succeeding only when a company fails.

On the other side of the coin, though, folks argue that short selling isn’t a new loophole or a devious way to exploit the market. It has existed in some form since the markets themselves began. Others explain that the complicated, messy, and tricky world of investments isn’t intended to be fair and that the ends justify the means. Shorting can also be a way to expose fraud — often, it’s the investors who first notice that a company is in trouble. The practice also helps regulate the market, providing accurate price discovery.

Whether you are comfortable with short selling or not is a decision only you can make, using the resources that we are dedicated to providing. If you want to stay abreast of the most up-to-date, unbiased investment news and educational content, why not join us?