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What is Short-Selling? A Layman's Description

Recent events have thrust the concept of short-selling stock into the spotlight of the mainstream media, and many pundits (even some who do not typically cover investing-related topics) have thrown their hat into the ring and begun to cover the concept of short-selling and what it means. The gracious definition of short selling is that it is a time-tested way to keep the market honest by highlighting over-valued stock.  Simplistically speaking, short-selling means that you commit to sell a stock at less than its current value in a specific period of time.

What is short selling?

A trader (not an investor, which is by definition a buy and hold “long” stockholder) borrows a stock they think is overvalued.  They then hold the stock anticipating that the price will drop by a set date.  If the price drops, they will then be able to buy the stock for less than what they borrowed the stock for, and they will have made money.  If instead the price goes up they will be forced to buy the stock for a higher price than what they sold the stock for, losing money.   

Ordinarily, when an investor purchases a share of a stock for $x, their losses are limited to $x: The value of the stock you hold can fall to $0, and what you’ve paid for the stock is lost. Shorting a stock on the other hand is highly risky because if the price continues to rise, the losses can be unlimited (by whatever amount the price rises).  On or before the set date, the  short sellers are required to buy the stock at the market price.  If the stock has increased and the short seller borrowed the money using margin,  they often must sell other “long” positions to provide them with the cash to settle the short position.  Combined with the “long” buyers of the shorted security, this can actually drive the stock being shorted much higher and the rest of the market lower (as other stocks have to be sold to create cash to cover the short position). 

The last couple of months trading in GameStop (stock symbol GME) offers an example of how the use of trading platforms and funding sources can thwart short sellers (at least temporarily).  GameStop, a retailer struggling for years, has become the center of these opposing forces. While GameStop has attracted traditional short sellers (mostly hedge funds) because of its dire outlook, an opposite force has surfaced supported largely by WallStreetBets (WSB), a Reddit forum for unconventional stock traders (mostly new and inexperienced traders who are flouting fundamentals). While some large institutional investors and fund managers are shorting GameStop, WSB is promoting sizeable numbers of its followers to buy the shares, counteracting the short sellers' efforts and pushing the GameStop share price to almost unbelievable levels (from $20 per share in December, 2020, to well over $300 per share). Because GameStop generally attracts low trading volume it does not take nearly the number of investors acting in unison to influence the stock price as it would for more widely traded stocks (like stocks on the publicly traded markets). Sadly, after all the news media hype, this is going to end badly for the vast majority of the traders involved; however, some “long” traders will quietly exit the stock at the right time (and claim their brilliance) and some short sellers will return to the market after the hype passes (or the long traders exhaust their money and energy) and make money.  Most directly involved are going to lose their “proverbial shirts”.  The stock has already started a precipitous drop.

 The most important question you may have is how is this specific event going to impact my portfolio?  While many of us are reading the news with fascination, our long-term portfolio will likely not be impacted at all.  Unfortunately, short-term this will likely cause some significant market moves ups and downs, possibly for a few weeks. 

More concerning is that many people will eventually be hurt by their actions.  Then regulators and politicians will likely step in and take action to try to prevent this from ever happening again.  Which, if history repeats, will have mixed results. 

 

By Milt Fullen and Justin Seidenwand

 

About the Author: Milt Fullen is a CPA and CFP® with more than 30 years of experience in the financial services industry. He is a multi-year winner of Columbus Monthly’s Five Star Wealth Manager Award, and Fullen Financial Group ranks among Columbus Business First’s top fee-only financial planning firms in Central Ohio. We have helped over 200 individuals and families prepare for retirement, and we manage more than $180 million of assets on behalf of our clients. Our team of professional advisors has a wealth of experience and the best credentials in the industry, supported by the latest technology tools and a dedicated client service team.

Contact Milt by email: This email address is being protected from spambots. You need JavaScript enabled to view it.

 

About the Author: Justin Seidenwand is an Associate Financial Advisor at Fullen Financial Group. He is a 2019 graduate of The Ohio State University, earning a Bachelor of Science in Consumer and Family Financial Services with a focus in Family Finance. While working to complete his education at The Ohio State University, Justin spent several years working in the telecommunications industry, and was also a formally-trained chef, attending vocational school for culinary arts while still in high school. In addition to his academic and professional achievements, Justin is also a six-year veteran of the Ohio Army National Guard, serving as a Military Police Sergeant in a team-leader capacity. 

Contact Justin by email: This email address is being protected from spambots. You need JavaScript enabled to view it. 

Disclaimer:

All expressions of opinion reflect the judgment of the authors on the date of the post and are subject to change. All investments and investment strategies have the potential for profit or loss. · Content should not be viewed as an offer to buy or sell any of the securities mentioned or as personalized financial advice. Legal and tax advice is general in nature. You should always consult an attorney or tax professional regarding your specific legal or tax situation. Fullen Financial Group is not engaged in the practice of law. · Hyperlinks on our posts are provided as a convenience. We cannot be held responsible for information, services or products found on websites linked to ours.