Meme Stocks and “Shorting”: An Introduction to Short Selling
A few weeks ago, the news was suddenly filled with stories about “meme stocks,” in particular the US video game retailer GameStop Corp (GME). Followers of the Reddit community Wall Street Bets began buying up GME, causing a huge runup in the price, at least in part, to stick it to a hedge fund that held a substantial short position in the stock.
I’m not going to dwell on the rationale, legitimacy, or possible manipulation of naïve members of the Wall Street Bets community. Rather, in the following I will explain what is involved in the short selling of stocks and why someone might want to engage in the practice.
In order to sell stocks short, you need a margin account. In general business terms, margin more often refers to the ratio of profit to revenue, the profit margin. In the investment world, margin refers to an account that allows you to borrow from your broker to purchase an amount of stock greater than the amount of cash you have in your account.
A margin account is distinguished from a cash account. A cash account requires you to pay for any purchase in full. No borrowing is allowed.
Long vs. Short
Long: Buy Low, Sell High
Most investors hold “long” positions in their accounts. This simply means you have bought a stock and you own it. For example, you buy 100 shares of GME. That means you are long 100 GME. If, a few days or weeks after buying those shares, you decide to sell them, you are simply selling those 100 shares. You have converted your shares back into cash.
Now, let’s suppose, you bought those 100 shares of GME, but you wanted to buy them on margin. You would need to put up at least 50% of the value the shares. If we assume GME is trading at $50 per share, you need to be able to pay at least 100 x $50 x 50% = $2,500. That is your minimum margin requirement. Correspondingly, the maximum loan value that your broker is willing to extend on GME is the balance, which in this case also happens to be 50% or $2,500.
The above is a description of a long position bought using margin, essentially borrowing cash from the broker to allow you to make a purchase. You are using leverage, not altogether different than buying a home using a mortgage. Similarly, there is interest to be paid for using borrowed money.
Short: Sell Short High, Buy to Cover Low
Given the general positive trend of the stock market over the long term, most people tend to hold long positions in their accounts. For most of us, if we thought a stock was not worth holding, we might simply choose not to buy it or, if we already owned it, to sell it so that we do not expose ourselves to a loss. However, some investors may be convinced that certain securities are headed for a downturn and believe that they can profit from this expectation. So, instead of the above scenario, where one uses margin to borrow money and buy long, these investors will borrow shares to sell short.
Let’s imagine you think that after its recent highs, GME is still way overvalued at $50 per share and is destined to soon return to where it was near the beginning of January 2021, at about $20 per share. You want to sell the shares now at $50 per share and buy back to cover your short position at $20 per share, perhaps a few weeks later. Your broker has sufficient shares in its inventory to allow you to borrow 100 shares and you sell them for $50 per share, resulting in $5,000 coming into your account. However, the 100 shares of GME show as a negative position in your account, since they are shares that you sold without owning them. In addition, since you borrowed those shares, there is a risk you are taking on. The shares might go up in value, which would be bad for you. To mitigate that risk, your broker insists on you putting up additional collateral to cover that risk.
Let’s suppose you have a margin account with $100,000 worth of investments in it. Let’s further suppose that all of the investments in the account are the most marginable stocks available, requiring you to maintain only 30% equity in each position. Thirty percent of $100,000 is $30,000, meaning your account has a loan value of up to $70,000. However, now you have shorted those 100 shares of GME. Yes, $5,000 came in, but that’s not enough. GME has a 150% margin requirement, which means that 100% of the value of the position plus an additional 50% is required to be set aside to allow you sufficient funds to cover your short position should this trade go against you. Fifty percent of $5,000 is $2,500 so the loan value of your margin account is reduced from $70,000 to $67,500.
Imagine that a week after you short GME, the stock goes up to $60 per share. This is not what you were anticipating. Your broker had set aside the proceeds from the sale plus an additional 50% for a total of $7,500. Using that same 150% requirement, you are now required to come up with an additional $1,500 (100 shares x $60 x 150% = $9,000) to meet your new margin requirement of $9,000. You are losing money.
Fortunately for you, the upward trend reverses and two weeks later GME drops to $30 per share. Your broker calculates this movement each day in a process called “mark to market.” Your latest margin obligation is now only $4,500 (100 shares x $30 x 150%). You are making money and the loan value of your margin account is increasing.
Finally, you close out your position at $20 per share in a “buy to cover” trade that eliminates the shares owed. Your gain is ($50 – $20) x 100 = $3,000.
Not all short sales work out this nicely, though. What if you get caught in the situation of the hedge fund in the GME story from late January 2021? You may have heard the term “short squeeze,” where demand pushed up the price of the stock and forced short sellers to cover their short positions at prices much higher than they sold them for.
Another thing to consider is if you have shorted a stock that pays dividends. If a dividend was paid during your holding period, since you hold a negative position, you need to pay the dividend. This is potentially an extra cost of short selling.
I’m not much for borrowing to invest, whether you want to take out a loan to contribute to your RRSP before March 1 comes around or borrow in a margin account to buy long or sell short. Yes, the leverage from borrowing does magnify your potential gains, but it also magnifies losses. I think that most people will sleep better by minimizing those sorts of risks.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.