Shorting, or short selling is a finance practice that investors use when the price of a company share is falling. Shorting is when an investor borrows shares from a broker and immediately sells them, thereby making money before the share price falls. When the share price falls, the investor can then buy the shares at the new low price and return them to the broker.
This sounds great in theory, but the practice is a lot riskier. The old adage holds true: if something sounds too good to be true, it probably is. It’s worth remembering that shorting is banned in France, Belgium, Spain and Italy, and that this ban also applies to stock from those countries.
Why is shorting a bad thing for investors?
Read any investment expertise website and you’ll see warnings that shorting should only be practiced by experienced traders. This is because it is a very risky strategy and if it goes wrong, you could lose your shirt.
The problem with shorting is that share prices can go up as well as down. Because the shares have been both borrowed from a trader and sold on, the investor will have to buy them at some point, even if the price increases. For example, you could have sold your borrowed shares at £50 per share, anticipating buying them back at £20 per share and making £30 profit. But if the company, say, attracts a major new investor or buys a profitable company, the price of the shares will go up. Then you will have to spend more money buying the share to give back to the broker than you originally spent.
There is no inherent limit to how high a stock’s price can rise. This means that short sellers risk losing an unlimited amount of money with their strategy.
This is in contrast with taking a long position (simply owning the stock), where the investor’s loss is limited to the cost of their initial investment.
How does shorting affect businesses?
Another problem with shorting is that it doesn’t affect businesses in any positive way at all. When it goes according to plan, the only person to benefit is the investor. We know that people play the stock market both to try and get rich and sometimes for the “fun” risky element. However, when they invest in a business that is on the rise, the money that they put in does actually benefit that business and help it grow. In turn, this helps the economy of the country where that business is based. Short sellers, on the other hand, are only hoping that a business will fail.
What happens when lots of investors all sell short at the same time?
Two things can happen when a lot of investors become short sellers at once.
Firstly, lots of people all investing at once creates a buzz around the company, which causes the shares to rise in price. This is called a short squeeze and means that all the short sellers will lose money. It is likely that they will all sell at once, in order to minimise their losses.
Secondly, all this activity could push up the price of the share higher than the company is actually worth. This means that people who have long-term investments in the company, such as its owner, will suddenly get rich, exposing them to accusations that it was all a set-up.
Why has shorting been in the news recently? What happened at GameStop?
GameStop is an American chain of video game shops. Having fallen foul of the online shopping trend, in 2019 its shares were losing value. After that, investors, following the advice of online stock market Reddit forums, took the opportunity to short sell. The investors ranged from large investment companies and hedge funds to teenage business students. The short sellers came in such large numbers that the share price was driven up – a short squeeze. The higher the price rose, the more money the short sellers were going to have to pay out, so they started selling quickly to minimise their losses.
Meanwhile, traditional “bullish” investors, noting that GameStop shares were on the up, decided to start buying, which pushed the price up further. Other interested parties included gamers who were keen to support their industry. At this point, some brokerages, including investment app Robinhood, took it upon themselves to halt the sale of GameStop shares. This was to protect the big investors who had shorted and were standing to lose millions. This left retail investors (ordinary people who choose to invest in the stock market) out in the cold.
Since the start of February 2021, GameStop shares have been declining in price, erasing an estimated $27 billion in value – $27 billion that the company was never actually worth.
Is the GameStop short squeeze a turning point for the stock market?
What the GameStop crisis highlighted was that there is one rule for hedge funds and brokerages and one rule for everyone else. All investments come with risk attached and investors understand this. It is unfair to protect large interests but not small ones (particularly when you’re calling yourself Robin Hood!).
The other point raised is that shares are being bought and sold at artificial prices that do not represent a company’s performance. These artificially inflated prices increase the risk for everyone who invests in the stock market. If you have an ISA or a savings account, that’s you too.
There have also been concerns that the recent activity around GameStop’s shares has been fuelled by the internet. This is because online tools allowing investors and brokers to drive trends in whatever direction they choose. Internet algorithms are a great tool for driving trends, but it’s important they’re used responsibly.
The brokerages behind the trading halt have come under severe criticism from politicians and market commentators in the United States. Senator Elizabeth Warren, writing to the Acting Chair of the US Securities and Exchange Commission, criticised hedge funds who have “treated the stock market like their own personal casino while everyone else pays the price.”
In addition to criticism from public figures, many individual investors have filed lawsuits against Robinhood for halting trading.
The US Securities and Exchange Commission are now reviewing the crisis – it will be very interesting to see what the review uncovers. A hearing will be convened by the US House Financial Services Committee on 18 February; witnesses will include key players and representatives of Robinhood. This could be a pivotal moment – will it mean complete shake-up of the stock market?
Conclusions
Shorting is a high-risk strategy: high stakes gambling that comes with no benefit to the business in which you’re investing. Recently it has led to the dramatic GameStop short squeeze, which could be a catalyst for a change to stock market practices. While retail investors are advised to leave shorting to professional traders, there is clearly an argument for following France’s example and banning shorting altogether.
Image Credits:
- GameStop: WikiMedia
- “the pink bubble”: Unsplash/Hillbers
