What’s the Deal with Short Selling Stocks? (Article)
What’s the Deal with Short Selling Stocks?
By now, you’ve likely heard about a handful of stocks that surged in price over the last few weeks. It wasn’t because those companies released exciting new products or posted strong operating results. In fact, quite the opposite. These companies are facing serious challenges threatening their relevance and even their existence. So why were their stocks rallying?
Let’s start by introducing the concept of a short squeeze. An institutional investor (like a hedge fund) expecting a stock to decline in price might try to profit by “shorting” shares. That is, they will borrow the stock from someone that owns it, sell those shares into the open market, and then try to buy them back later at a cheaper price. It’s “buy low, sell high,” but in reverse order–sell high, then buy low.
If all goes according to plan and the stock price drops, the investor repurchases shares, returns them to the original owner, and pockets the difference in value. Voila. However, if the stock price starts to rise, losses start to accumulate, and the investor has a decision to make: hold out hope for a price decline, or buy back shares now to exit the position (and realize the loss).
Now imagine a scenario where a lot of institutional investors were betting against (shorting) the same stock, and the price of that stock suddenly starts to jump. A lot. All those investors see losses mounting and grow nervous about the stock going “to the moon” and inflicting (theoretically) infinite losses. Many will decide (or be told by their broker) to close their positions, and as they do, they compete to buy shares in the open market and push the stock price even higher. This is known as a “short squeeze.”
This is the phenomenon that led to recent price spikes for stocks of companies past their prime. While short squeezes aren’t uncommon, the trigger this time is what stands out. Individual investors (read: day traders) realized institutional investors were betting so heavily against a few companies that they’d be susceptible to a short squeeze if those stocks started rising. So, they coordinated via internet message boards and started pouring money into targeted stocks, driving up prices to a point where short selling investors clamored to buy back shares to limit losses (pushing prices even higher).
It’s a fun story because message board readers early to the game made a lot of money, and the media loved it because David (individual investors) seemed to pull one over on Goliath (hedge funds). But, short squeezes by nature are a temporary occurrence and only last until a balance in supply/demand for shares is reached. In fact, with rampant speculation subsiding as message board users lose their nerve and take profits, the pumped up stocks have already started hurtling back towards earth.
Internet message boards have been around a long time, so why is this happening now? In a way, it’s a perfect storm of factors: 1) The pandemic has kept people at home, leading to more free time and more disposable income via lower spending, 2) The government has been funneling money into citizen bank accounts in response to covid-19, and 3) Most stock trading platforms made it free to trade in 2019 by eliminating commissions. As long as these conditions remain intact, expect the game (most resembling whack-a-mole) to continue. As investors chase the hot idea of the day, it could cause individual stocks, commodities, and cryptocurrencies to whipsaw.
So what’s a retirement investor to do? It always sounds easier than it is, but keep the emotion out of it, and stick to your long-term investment strategy. If you’re anxious that speculative behavior is a bad omen for the stock market, resist the urge to take a lot of chips off the table. The economy and corporate earnings are improving, low interest rates are a disincentive to own a lot of bonds, and piled up cash from increased savings and stimulus could support market prices if it keeps filtering into stocks. If anything, make sure your retirement account is broadly diversified to help insulate you from boom-and-bust cycles in individual stocks.
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