Short sellers: What they do, why they do it and how they make money
WASHINGTON — Short sellers. GameStop shares. Robinhood. Reddit. Redditors. Hedge funds. Stock market wipe-outs. They’re related stocks and stock market terms, related players and related firms, investors and philosophies. And they’ve all been in the news this week, big time as Wall Street stock markets plunged, surged and crashed again to close out the last trading week of January. Maybe it’s time to separate out from The Evolving Big Story and try to explain the complicated and seemingly perverse action in the stock market trading and investing universe this week. What better way to do this than to explain exactly who short sellers are, what they do, why they do it, and how they make money when stocks go down?
The following explanation is a bit simplistic and doesn’t explore every nuance of the wonderful world of short selling. But it’ll give you an idea how it works if you’ve never understood it before. But before you even think of joining the strange world of short sellers, be sure to consult with your broker or investment advisor. Right now, let’s get familiar with the terms and how this game works.
The long and the short of investing: Establishing a long position
A bit of explanation for investing newbies before we proceed. When average investors decide to try making money in the stock market, they and / or their stockbroker look to buy shares of excellent but undervalued companies. The reason? If most analysts reason that these companies are likely to increase earnings, and, more importantly, profits, they know that such stocks are likely to increase in per share value. So, based on reason and on nearly two centuries of patterns and statistics, they believe these shares are a bargain today because they’ll eventually increase in value.
So, upon completing their research and poring over analysts’s recommendations, such investors may decide to buy 100 shares of Company X for $10 per share. That’s because they’re convinced that these shares will increase in value to, say, $15 per share over time, which could range anywhere from a day to a year or longer. If and when the stock meets the investor’s objective price, the investor can sell it for a profit. That’s the way most people think you make money in the market, and in general, they’re right. Buy low, sell high.
Meanwhile, sometimes they get a special bonus for sitting on those shares until they meet their objective. If that $10 stock pays a quarterly dividend, investors can even make money even if it just sits at $10 for a time. Nice. Of course, those wonderful shares of Company X could run into problems and drop to $5 per share, which could result in a loss. But for the sake of this explanation, let’s forget that for now. Buy low, sell high. In the business, that’s called “owning shares of stock.” Or even better, “establishing a long position in Company X.”
What happens if your long position heads South?
Contrarywise, most investors also figure that if Company X turns out to be a stinker and heads down to $5 per share, they’d consider selling it before it heads for zero and simply take a $5 loss per share. Some will put that money back in a bank savings account paying 0.01% these days. Or perhaps inter the money in a short term bank CD for, say, a generous 0.05%. Others may write off the loss (which, within reason, you can deduct from your gross income, reducing taxes). And then they may try another investing idea. So, you buy a stock, you eventually sell it for a profit (or, * choke * a loss) and then try again.
The long and the short of investing: Establishing a short position
But what if you could make money when a stock goes down? Many investors and potential investors think you can’t do that. But you can. The answer here is that in addition to making money when your long position goes up, you can make money when a different kind of stock position goes down. Namely, a short position. Or a short sale. That’s what short sellers do.
To sell a stock short, an investor or institutional investor must first be operating within a margin account. As opposed to the usual everyday, unleveraged cash account, a margin account offers investors a certain amount of instant credit based, essentially, on the size and value of the account. This enables the investor to buy shares of stock on credit (“on margin”). This makes use of the leverage that allows investors to pick up more shares of a stock than they could for cash on hand.
Ditto for purchasing stock options, which are complicated, time-limited “bets” on the direction a given stock might take. But options are for another discussion, though we’ll mention it briefly again here.
The credit in a margin account enables investors to sell x shares of stock “short.” Shares that such investors don’t actually own. How? Is this legal? Can such things be?
Of course they can. It’s simple. Our investor’s brokerage firm borrows the shares of stock — call it Company Z— on behalf of the investor. The brokerage borrows the shares from another anonymous customer whose shares reside in that investor’s margin account. The brokerage then sells those shares in the market, taking the proceeds and placing them into the short selling investor’s account. (Forget the accounting for this for a moment.)
A profitable round trip on the downside: Nirvana for all short sellers
Our short selling investor has just placed a bet that Company Z is a stinker. In fairly short order, our investor believes that Company Z shares will drop considerably in price when the market finds this out. If and when that happens, our investor then purchases the number of shares he needs to pay back that other anonymous investor, but at a (presumably) much lower price. The original investor retains much of the cash he took in by selling the stock he didn’t own by buying it back on the cheap and pocketing the difference.
There are other complications here, including the fact that the brokerage handling our short seller’s account charges margin interest on the value of the borrowed shares as long as they remain borrowed. This can also erode the our short seller’s temporary cash stash. So usually, most small time short sellers don’t want to keep their shorts on (intentional Wall Street punnage) for very long, since they can lose potential profits via interest charges.
Institutional investors like hedge funds, working with much bigger amounts of money, can get volume deals from the brokerage firms they use, giving them an advantage over the little guys (of course). Among other things, this allows them to profitably hold their shorts for a longer period of time, particularly if the stock begins to sink. Even more complexity is involved. But again, we’re trying to keep things simple here. So we’ll leave it there for now, since I don’t want you to fall asleep.
Investors buying a stock want it to go up. Investors shorting a stock want it to go down. Both can make money.
Suffice it to say that short sellers make lots of $$$ when the stocks they short go down. Just like investors holding long positions in profitable stocks can sell them for a profit at a higher price. In other words, investing in stocks is really a two-way, bi-directional game. I used to teach adult-ed students how all this works in a popular community college course I taught several years ago, and it was one of the toughest jobs I ever had. Newbie investors and even some veteran investors had a hard time understanding the concept. They tended to regard short selling and short sellers as dodgy propositions. Some felt that short selling is somehow evil and illegal.
I’ll grant that short selling seems perverse. But it’s not.
The positive effect of short-selling is that it always guarantees a certain amount of trades – buying and selling – on both sides of the trade, long and short. This is quite helpful in a market where a hated stock that becomes illiquid. There are soon so few trades that investors who want in may not be able to buy, or investors who want out may not be able to sell. Short sellers, in a way, provide a real service for distressed investors looking to get out of a stock. Why? Because, if they’re short and have met their downside objective, they’re willing to BUY those distressed shares, thus giving desperate sellers a way out.
One final note on potential losses for short sellers
Here’s an important fun fact as you read article after article about those hedge funds that may have shorted a ton of GameStop stock (trading symbol on the NYSE: GME). If investors buy 100 shares of a $10 stock (a long position), the most they can lose is $1,000 (assuming commission-free trades), even if the company issuing the stock suddenly goes belly-up.
But a short seller’s potential loss is INFINITY. Since he’s dealing with borrowed stock underwritten with borrowed money, brokerage firms have limits as to how far they’ll let those shorted shares blast upwards. That’s because this erodes the short-seller’s equity position on the loan. Once the firm’s limit is exceeded, the firm will demand the investor pony up the required additional fund toute de suite. Or, the brokerage firm will start selling other stocks in the investor’s portfolio to raise more cash to cover the loss. Plus, they’ll close out the short position by buying the stock back. That’s called a “margin call.”
Of course, short sellers may have established in advance their own threshhold of pain, and can always exit earlier for a loss on their own. But in a panicked market, like the one we saw last week for GME and other shares, no doubt some individual short sellers and hedge funds got caught totally unawares until their brokerage firms started selling them out.
A final, real-world story
Back in my own days as an retail stockbroker, I occasionally had to get on the phone (the dial-up kind) to one of my short sellers and tell him my firm had just issued a margin call in his account and needed x amount of dollars added to that account within 24 hours. So would he get in his car and get me a check for the amount of the call right now? Or should the firm start selling stocks in his portfolio to close out his short and / or clear up the margin call.
I dreaded those calls. The customer’s standard initial reaction involved an outraged cascade of colorful metaphors and undeleted expletives mostly directed at me and my below-normal IQ. Threats to hire a legal dream team to screw me and my firm forever were value-added commentary.
As always, caveat emptor. Be careful if you think you want to play this game.
But today, I just get to tell you how this works. Or doesn’t. Stay tuned for more info on the actual Reddit vs short sellers story, which remains ongoing.
— Headline image: Cartoon by Garrison. Reproduced with permission and by arrangement with Grrrgraphics.com.
Resized to fit CDN format.