By now, you’ve probably heard the story about the historic “short squeeze” of GameStop’s stock. While many successful investors profit when stocks rise in value, some investors bet on the opposite—profiting from a stock’s decline in value. As a result, short Selling is an appealing strategy to some traders but too high a risk for others. Today’s article will unpack the pros and cons of Short Selling.
How Does Short Selling Work?
- Short Selling is an investment process that increases in value as a company’s stock price declines.
- Short Selling requires borrowing shares from an institution, selling those shares to the public, then repurchasing the shares to pay off the initial debt.
- The required stock purchase to close the short sale may sometimes lead to a Short Squeeze.
The average investor in the stock market buys a position (stock, ETF, mutual fund, etc.), hoping the investment price will increase. The traditional idea is to invest in hopeful and trustworthy companies that will provide a positive rate of return. But what if you think a company will fail and possibly go bankrupt? You do not want to bet on the company’s success, but how do you bet on the company’s failure? The solution is Short Selling.
What is the Benefit of Short Selling?
We will use the example below to illustrate the idea in simpler terms:
- Investor A borrows ten shares of ABC company valued at $10 each from their brokerage firm. Thus, the total debt is ten shares.
- Investor A sells these shares on the open market and receives the $10 per share ($100 total)
- Two weeks go by, and the share price of ABC company is now $6 per share.
- Investor A buys ten shares of ABC company for $6 each ($60 total) and pockets the remaining $40 as profit.
- Investor A then uses the newly acquired shares to pay off the original debt to the brokerage firm.
What is the Risk of Short Selling?
There are plenty of risks to be aware of regarding Short Selling. The process may sound appealing, but there are vital factors to consider with this strategy. There is limited upside available within the short sale since the lowest a stock can go is $0, so the most potential for a short sale is the current dollar value per share. The most a company can lose is its current value. However, on the other hand, a company can grow and grow and grow to an infinite size. This means that a short sale has unlimited downside available. If the stock keeps going up, the short sale will continue to lose money.
To close out the short sale and walk away, you must repay the original amount of shares borrowed. If a stock continues to rise, you will be forced to repurchase the shares at a higher price to pay off the debt.
Pros and Cons of Short Selling – Summarized
In summary, the pros and cons of Short Selling are a topic of debate among investors. Short Selling is a very aggressive and risky strategy, so it should only be utilized by those comfortable with the risk and non-essential savings.
Have More Questions?
If you’d like to discuss your portfolio’s position from a risk standpoint, please reach out to us immediately. In addition, if you’ve had any changes to your income, job status, marital status, 401K options, address, or any other financial changes, don’t hesitate to contact the team at Summit Financial today.
Zachary A. Bachner, CFP®
with contributions by Robert L. Wink, Kenneth R. Wink, and James D. Wink.