What it is, why it is risky and how a “squeeze” happens

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

That is, the short sale. It usually involves selling shares borrowed from a stock in the belief that the price will go down, at which point you will buy shares at a lower price to pay off what you borrowed (later). And it’s not just the province of hedge funds or other large investment institutions. Individual investors, for better or worse, can also use it if their intermediation approves it.

“For my clients who want short stocks, I tell them it’s usually 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 on the WallStreetBets Reddit chat room, have been accumulating at Gamestop, AMC Entertainment and other stocks that hedge funds were counting on to go down.

In a nutshell: All purchases raised prices, which means that fund bets were wrong and they have lost billions of dollars. So far, for GameStop short sellers alone, the loss is at least $ 5 billion, according to S3 Research.

“These investors have access to information, they know which companies have a strong short circuit and they communicate with each other,” Johnson said. “I wouldn’t be surprised if they kept doing it … it’s like Occupy Wall Street Part 2.”

While this group demonstrates how retail investors can reach hedge funds where it hurts them, the ongoing battle also demonstrates the risk of short selling.

You usually buy stocks with the idea that they will rise in price and you will make a profit when you sell them.

With short-term selling, the end goal remains a profit. However, the transaction is based on your view that the shares are overvalued and will therefore fall in price.

The general process: brokerage shares are contracted and sold at the current market price (which, again, he thinks will fall). Ideally, your point of view is correct, and when the price has dropped, you buy shares at a lower cost to pay for the ones you borrowed. A simplified illustration: they run out of $ 7 shares. It slips in price and you buy it for $ 2. Your profit is $ 5.

However, if the price goes up, at some point you should end the transaction, that is, you should buy these shares to amortize the brokerage. So if these $ 7 stocks start to rise and you sell them at $ 10 to cover your short position, you have lost $ 3.

“Most investors think the risk is only downward,” said CFP Matt Canine, East Paces Group’s chief wealth strategist in Atlanta. “When you buy a free stock, your losses are finite: if you buy at $ 100 and go to zero, you will lose $ 100.

“But if you reduce it and it gets to $ 200, $ 300, $ 400, etc., your losses will add up,” Canine said. “The upside risk is unlimited.”

When stocks are very short and investors buy stocks, which raises the price, short sellers start buying to hedge their position and minimize losses as the price continues to rise.

This can lead to a “short cut”: short sellers still have to buy stocks, which causes the price to go up even more. (This is what happened with the short-term stocks driven by the crowd of Reddit investors).

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

When the value falls below this threshold, your brokerage will require you to reset your account. Your broker may also ask you to cover your short position when the price has risen.

How does the Reddit investor saga against hedge funds end?

“Some people will make a lot of money,” Johnson told Delancey Wealth Management. “But there will be people who … come in and lose the shirt.”