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

You may have heard that an army of retail investors has managed to use one of the hedge fund’s common investment strategies against them.

That is, short selling. It usually involves selling shares borrowed from a stock with the belief that the price will fall, at which point you would buy shares at a lower price to pay back what you borrowed (later). And it is not just territory for hedge funds or other large investment entities. Individual investors – for better or worse – can also employ you, if your broker approves.

“For my clients who want to short-sell shares, I tell them it’s generally not a good idea,” said 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, have focused on Gamestop, AMC Entertainment and other stocks that hedge funds have seen a downfall.

In short: all purchases raised prices, which means that the funds’ bets were wrong and they lost billions of dollars. Year-to-date, only for GameStop short sellers, the loss is at least $ 5 billion, according to S3 Research.

“These investors have access to information, they know which companies have big short sales and are communicating,” said Johnson. “I wouldn’t be surprised if they kept doing this … it’s like Occupying Wall Street Part 2.”

While this group is demonstrating how retail investors can target hedge funds where it hurts, the ongoing battle also shows how short selling is risky.

Typically, you buy stocks with the idea that their price will increase and you will make a profit from selling them.

With short selling, the ultimate goal is still profit. However, the transaction is based on your view that the stock is overvalued and, therefore, its price will fall.

The general process: you borrow shares from your broker and sell them at the current market price (which, again, you think will fall). Ideally, your view is correct, and when the price drops, you buy shares at that lower cost to pay for the ones you borrowed. A simplified illustration: you sold a $ 7 share. The price slips and you buy it for $ 2. Your profit is $ 5.

However, if the price goes up, at some point you will still need to finalize the transaction – that is, you will have to buy that stock to pay the broker. So if that $ 7 stock starts to go up and you sell it at $ 10 to cover your short position, you will lose $ 3.

“Most investors think the risk is just on the negative side,” said CFP Matt Canine, senior wealth strategist at the East Paces Group in Atlanta. “When you buy a stock right away, your losses are finite – if you buy $ 100 and it goes to zero, you lose $ 100.

“But if you sell short and reach $ 200, $ 300, $ 400, etc., your losses are compounded,” said Canine. “The risk on the positive side is limitless.”

When a stock is strongly sold and investors are buying shares – which pushes the price up – short sellers start buying to cover their position and minimize losses as the price continues to rise.

This can create a “short squeeze”: short sellers continue to have to buy the shares, driving the price higher and higher. (This is what happened to the short shares targeted by the Reddit crowd of investors).

Generally speaking, you can only make short sales using a margin account. This is essentially a loan from your broker, which will charge interest and require you to maintain a certain level of funds in that account.

When the value falls below this limit, your broker will require you to reset the account. Your broker may also ask you to cover your short position when the price goes up.

And like the Reddit vs. Investor saga. hedge funds ends?

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