Today, we're going to look at what short selling is, how it works, the risks and costs associated with short selling, and hopefully this information will help you better understand what happened with all of the hedge funds and people shorting GameStop, AMC, and all of those stocks we heard about in the news.
What Is Short Selling?
Short selling is a high-risk way to profit from falling stock prices.
You're basically betting that a stock price is going to go lower.
In the stock market, there are two very broad ways that you can profit from stocks:
- Taking a long position
- Taking a short position
Let's look at the difference.
Long Position vs. Short Position
What Is a Long Position?
A long position is probably the typical way you think about the stock market.
You want to buy a stock at a low price and sell that stock at a higher price, making a profit.
In other words:
Buy low → Sell high
The higher the price is when you sell it, the more profit you will make.
That is called a long position.
What Is a Short Position?
A short position is a bit more confusing, but it's basically the exact opposite of a long position.
Instead of buying low and selling high, you want to:
Sell high → Buy back low
You profit when the stock price goes down.
When you short a stock, the lower the price goes, the more you can potentially profit.
Short Selling Is Not the Same as a Short-Term Investment
I want to make it abundantly clear that when we're talking about taking a short position or a long position, we are not referring to short-term or long-term investments.
Whenever people say:
"I'm going to hold on to that stock short-term."
Or:
"I'll probably hold on to it long-term."
That's not what we're talking about here.
When you short a stock, you're trying to profit from the stock price going down.
So, shorting a stock is not the same thing as making a short-term investment.
How Does Short Selling Work?
Now that we have that out of the way, I'll explain short selling in a very simplified way.
We'll build this scenario around a guy named John.
Step 1: John Thinks Tesla Will Go Down
For whatever reason, John thinks that Tesla stock is going to go down in price.
In order to make money from that guess, John wants to short Tesla.
John is going to have either a broker or a brokerage.
For simplicity, we'll just say that he has a broker.
Step 2: The Broker Finds Tesla Shares
The broker can try to find Tesla shares for John by either going to an institution, another broker, or maybe even another customer's portfolio.
Regardless of where the shares come from, the broker finds a share of Tesla for John and borrows it.
Step 3: The Broker Sells the Borrowed Share
The broker then turns around and sells that share of Tesla on the market for John.
Let's say Tesla's stock price is currently $1,000 per share.
So, if that one share of Tesla is currently selling for $1,000, that $1,000 will be credited to John's account.
Step 4: Tesla's Price Falls
As time passes, the Tesla stock price moves around.
John ends up being right, and Tesla falls from $1,000 to $700.
Because John was shorting the stock and betting that the price would go down, he can now profit by buying the share back at the current price.
When he buys it back, this can also be referred to as covering his position.
Step 5: John Covers His Position
John lets his broker know that he wants to cover his position in Tesla.
The broker buys one share of Tesla at the current price:
$700
The broker uses the money from John's account and then returns the stock to wherever it was originally borrowed from.