How to Bet Against a Stock
In 2020, a group of retail investors on Reddit gained global notoriety and were shining in the spotlight when they helped to drive GameStop’s stock value up astronomically. This caused major challenges for investors known as short-sellers, who were positioned and waiting for the flailing company to finally die.
Read More About Retail Investors...and how they differ from Institutional Investors.
Short selling is an investment strategy used for betting against increases in the future values of stocks. In this case, short-sellers were counting on once-booming GameStop’s failure. So what is this risky trading technique? What are its benefits and drawbacks? How can it result in appreciable financial gains - or devastating losses?
There’s no “one way” to invest, and any smart investor knows that diversification is key to building a successful portfolio. This is why it’s so essential that you understand the ins and outs of the different ways to bet on (or against!) the market.
Read on, as we cover everything you need to know about how to bet against the market.
What is Short Selling?
Short selling is a stock trading technique based on speculation. Also called “taking a short position” or “shorting,” it involves selling borrowed stocks and hoping to repurchase them for a profit in the future. In essence, short selling is betting against the market.
A typical short sale scenario involves a stock trader, professional investor or hedge fund borrowing shares for a given company from a broker on a margin account. The broker may already possess these shares, allocate them from another broker’s holdings or simply borrow them from other willing clients with margin accounts.
In a nutshell, the steps of a short sale include:
- An investor speculates that a company’s shares will lose value soon
- The investor borrows many shares from a broker
- The investor then sells the shares on the open market
- When the stock’s value falls, the investor buys the same shares back
The investor then returns the shares to the lending broker and pays any interest fees incurred from the margin account transaction. The remaining monies are profit.
Benefits of Short Selling
When everything works out as intended, short-selling stocks can be quite lucrative. Some of the more attractive benefits to betting against stocks can include:
- Potential for large profits
- Limited capital investment required
- Possibility for leveraged investments
- Effective hedging technique to protect other holdings
However, it’s important to note that short selling is not something you should jump into quickly. Let’s consider some of the possible downsides to this risky investment strategy that’s based on betting against the market.
Risks of Short Selling
The risks of short selling center around not understanding how to bet against the stock market. Incorrect speculation about a stock’s price movement can cause investment disaster.
In a traditional trading model, an investor can only lose a maximum of the amount invested. For instance, if you bought $100 of stock, you could only lose a maximum of $100. And that’s if the price of the stock fell all the way to zero. Not likely, right?
In comparison, a short seller who makes a bad bet can lose much more than the full amount of the initial capital investment. Particularly for inexperienced traders, betting against a stock via short selling has downsides including:
- Potential for infinite losses
- Requires a margin account
- The incurrence of margin account interest
Another possible risk of short selling is the potential for short squeezing. Let’s take a closer look at the short squeeze.
What is a Short Squeeze
A short squeeze is a phenomenon that occurs when the performance and price of a heavily shorted stock are catalyzed by new buyers. Instead of the price dropping as the short sellers projected, the price of the stock moves upward, sometimes very significantly and rapidly.
Short squeezes put short sellers in a “squeezed” predicament. Remember that those shares were borrowed from a broker. They must be repaid within a certain time frame. Now, the short seller is forced to repurchase the shares at a higher price instead of the anticipated lower price.
This can cause short sellers to scramble to close their positions as quickly as they can. If the volume of traders racing to exit their positions is great enough, it causes a short squeeze.
Generally, when this happens, the short seller simply didn’t properly understand how to bet against the market. The wager can backfire and the investment can end up as a huge loss. This depends on how high the price of the stock soars, and how quickly a short seller decides to take the loss.
The recent event with GameStop is a prime example of how powerful the short squeeze effect can be. The company was very near financial death just 2 years ago. Unpredictable market changes occurred - many due to the power of social media - that transformed GameStop into one of today’s most active tradable companies.
Examples of Short Selling
Although it’s considered to be a novel investment technique for some new traders, short selling has been a strategy used by savvy investors for years.
For example, in the early 1990s, George Soros expertly shorted stocks for the British pound; an endeavor that netted him more than $1 billion in profit in less than 30 days.
Let’s consider how short selling can result in profit or loss with some straightforward examples.
Short Selling for Profit
How do you bet against a stock?
Assume that your broker lends you 10 shares of an ETF (Exchange-Traded Fund), REIT (Real Estate Investment Trust) or a tradable company. You quickly sell the shares for $20 each, which generates $200. Then you wait for the value of the stock to decrease.
Let’s assume that the value does decrease to $10 per share. You buy back all 10 shares for $100. You return the shares to the lending broker. You net $100 minus any applicable interest and/or transaction fees.
Good and simple, right? It could be. However, short selling is a high reward/high-risk trading technique. Betting a stock will go down doesn’t always pan out - and huge losses are possible for inexperienced traders.
Short Selling for a Loss
Consider the same scenario as above. You borrow 10 shares of a company on a margin account. You sell the 10 shares for $20 per for a total of $200. Then you watch and wait for the price to begin to drop.
However, in this case, let’s say the price of the stock does not drop. Instead, it begins to climb. Assume it increases up to a remarkable $50 per unit. The time comes to repay your loan to the broker. You have no choice except to take the loss. You have to buy the 10 shares back for $500. That means a whopping $300 loss for you.
If there’s still time left and you choose to, you can continue to wait for the prices to drop back to where you could at least break even. However, you need to be prepared that the price may continue to rise, meaning you could end up stuck owing much more. And the longer you wait to repay the broker, the more interest and fees you’re going to incur on the borrowed stocks.
Closing Thoughts
Short-selling stock is a high-risk, high-reward trading technique based on betting against the market. It’s founded on the investor’s speculation about unpredictable and ever-fluxing markets. Especially for the inexperienced, this type of investment strategy can be disastrous.
However, when done right (and with a little luck), it can also be a very lucrative strategy when an investor understands how to bet against a stock correctly. Does the idea of betting against the market excite you? Take the time to educate yourself and search for the best opportunities to utilize this strategy before making any serious short-selling wagers.
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