When investing in shares of publicly traded companies, an investor can go “long” or “short”. What do these terms mean, and how do they work mechanically through a brokerage? How much risk is associated with a long position versus a short position? What happened to short sellers during the GameStop short squeeze?
A long position is where an investor buys a stock with the expectation that the price will go up. As the price goes up, the investor makes money. In order for an investor to go long in a stock, they must buy the stock from someone who has sold the stock on the other end of the transaction. It’s important to remember in the investment world that on the other end of every trade there is someone who disagrees with the investment decision you are making. Whoever you buy that stock from either thinks it won’t go up, or that it won’t go up as much as a different opportunity available in the market. (Read our blog post on Opportunity Cost to read about the cost to every investment decision)
Once the order to go long on a stock has been placed, the trade will typically settle within 3 business days. This is the “Trade Date” versus “Settlement Date” timing difference. In today’s electronic brokerage world, trades settle very quickly. In the past, when stock certificates were paper, brokerages had to administer the change in ownership of the shares and record the accounting of those changes in their stock records. Your entitlement to the rewards and risks of a stock position begins the second after your trade is completed on the Trade Date. Remember, stocks trade in real time during the trading day. For very liquid stocks like Apple or Walmart, they trade thousands of times a second.
A short position is where an investor buys a stock with the expectation that the price will go down. Of course, the investor doesn’t own the stock long, because if they did, a price decrease would result in them losing money. Therefore, the investor must first borrow the stock from their brokerage. The brokerage handles this side of the transaction to determine who owns the stock being borrowed. In theory, you would assume that each short position must be assigned to actual existing shares in the company being shorted such that the total number of short positions could never exceed the number of shares in circulation. However, I understand that during the GameStop debacle, the hedge funds which were targeted held short positions which exceeded the entire float of the company. I don’t understand how this is allowed to take place or even how it mechanically can work. But anyway, the first step is borrowing the stock. The investor must pay interest on the stock loan during the period they have borrowed it, just like a regular loan.
Then, the investor proceeds to sell the borrowed price into the market. The investor then hopes that over time the stock price will go down so that the investor can repurchase the stock at a lower price so that it can return the shares to the lender. In theory, if someone borrows 1,000 shares at $50 per share and sells short at that price, and the stock drops to $25 per share, the investor has made $25,000 by being able to buy back the stock at a lower price than they sold it.
However, if the stock price increased to $75, the investor might find themselves in a short squeeze scenario. In a short squeeze, the short seller is squeezed into having to buy back the shares to return to the stock lender at a price higher than they sold it at. This means they need to put in more cash to be able to do so because the cash they got from selling the shares initially isn’t enough to buy back higher. Then in a cascading effect, the short seller’s purchase of the shares adds to the “bids” or demand for the stock on the long side, potentially pushing the price even higher. This is why brokerages require that shorting can only be done in margin accounts that have enough cash in them to cover the risk of the stock going higher.
The risk of unlimited losses from short selling stock is the main reason why I don’t participate in it. There are other ways to make money and reach your financial goals that don’t come with such disproportionate risk to return ratios.
They say in stock investing that you need to be able to afford to lose your entire investment in the event a company goes out of business. This makes sense and is a controllable level of risk because in a long position, your maximum loss is your initial investment. In a short position, your maximum loss is unlimited. Imagine if you shorted Bitcoin at $.10 per coin and it went to $48,000 per coin??!!
Be careful out there and manage your risk!