What it is, why it is risky and how a ‘pressure’ happens

You may have heard that an army of retail investors has succeeded in using one of the common investment strategies of hedge funds against them.

That is, short sales. It is usually about selling borrowed shares of a stock with the belief that the price will fall, and then you will buy shares at a lower price to repay what you borrowed (further below). And it’s not the province of just hedge funds or other large investment entities. Individual investors can also use it for better or worse if their brokers approve it.

“For my clients who want stocks short, I tell them it’s not a good idea at all,” says certified financial planner Ivory Johnson, founder of Delancey Wealth Management in Washington.

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Retail investors, led by those in the WallStreetBets Reddit chat room, are piling into Gamestop, AMC Entertainment and other stocks that hedge funds expect to go down.

In a nutshell: all the purchases raised the prices, which means that the bets of the funds were wrong and that they lost billions of dollars. According to S3 Research, the annual loss to GameStop short sellers so far is at least $ 5 billion.

“These investors have access to information, they know which companies are heavily short and they communicate with each other,” Johnson said. “I would not be surprised if they keep doing … it’s like Occupy Wall Street Part 2.”

While this group demonstrates how small investors can hit hedge funds where it hurts, the ongoing battle also shows how risky short selling is.

Usually you buy shares with the idea that they will rise in price and you will make a profit if you sell them.

With short sales, the end goal is still profit. However, the transaction is based on your opinion that the stock is too high and that it will therefore drop the price.

The general process: you borrow shares from your brokerage and sell them at the current market price (which again thinks you will fall). Ideally, your view is correct, and if the price has dropped, you buy shares at the lower cost to repay the loans. A simplified illustration: you get a stock of $ 7. It shifts in price, and you buy it at $ 2. Your profit is $ 5.

However, if the price rises, you will have to complete the transaction at some point, that is, you will have to buy the stock to repay the broker. So if the $ 7 stock starts to rise and you sell it at $ 10 to cover your short position, you have lost $ 3.

“Most investors think the risk is just on the downside,” said CFO Matt Canine, senior wealth strategist at East Paces Group in Atlanta. ‘If you buy a stock directly, your losses end. If you buy at $ 100 and it goes to zero, you lose $ 100.

“But if you short it, and it’s $ 200, $ 300, $ 400 and so on, your losses get worse,” Canine said. “The risk upside down is unlimited.”

When a stock is severely shorted and investors buy shares – which increases the price – short sellers start to cover their position and to limit losses as the price continues to rise.

This can create a ‘short press’: short sellers still have to buy the stock, which causes the price to rise even higher and higher. (This is what happened to the shortened stocks targeted by the Reddit investment crowd).

In general, you can only use short sales using a margin account. It is essentially a loan from your broker, which will charge you interest and require you to maintain a certain amount in the account.

When the value falls below the threshold, your broker will require you to top up the account. Your broker may also ask you to cover your short position if the price has risen.

About how the saga of Reddit investors versus hedge funds ends?

“Some people are going to make a lot of money,” Johnson told Delancey Wealth Management. “But there will be people who … get in and lose their shirt.”