I’m amazed it took this long…
After all, Facebook has been around since 2004… Reddit since 2005… and Twitter since 2006.
These platforms have existed for the last decade as forums for millions to share interests… as well as healthy – and very unhealthy – discourse.
But finally, retail investors have figured out how to use social media to band together and profit from one of Wall Street’s oldest moves – the short sell.
Short selling is not as straightforward as we might think… There’s actually a lot of nuance. And investors who aren’t aware of the mechanics ultimately end up stacking the deck against themselves.
That said, there is nothing sinister about short selling. I would argue that it is a necessity – a vital dynamic of capital markets. Short selling helps keep asset values in check. When a stock gets ridiculously overvalued, short sellers step in to sell the stock with the expectation that it will return to a more reasonable valuation.
Hedge funds focused on short selling often uncover accounting fraud or other corporate shenanigans that reveal a company isn’t quite what it represents itself to be. In this regard, short sellers do a great service to the markets and those who invest in them.
But there are some critical elements of short selling that normal investors should understand…
When we sell a stock short, we’re borrowing shares, selling them, and creating a liability. At some point we have to buy back the shares we sold and return them to the lender. Ideally, we’re buying back at a price lower than what we borrowed. If so, we make a profit… maybe.
Every short sale is done on margin and requires a margin account. And as there is a lender, there’s a cost to borrowing. Stocks that are considered easy to borrow – think large, highly liquid stocks – might have an annual margin interest rate of 5%.
But “hard to borrow” stocks can have a margin interest rate of 20% or more. That’s why profit is a “maybe.” A successful short sale has to be timed well, and the stock’s drop has to be large enough to cover what we paid in margin interest.
But it gets worse…
The “Impossible” Short
When we short shares of a stock that pays a dividend, we have to pay the dividend to the person who bought the shares that we sold. It comes right out of our brokerage account automatically.
Plus, the lender of our shares can call those shares back at any time. This is where retail investors can really take a hit. We don’t have the kind of leverage that a fund does to preserve our position.
For example, let’s say that we sold $20,000 worth of shares in a terrible company that was being hyped up, but that we believed was a fraud. The stock then runs up 40% leading into the company’s earnings announcement.
We’re not worried because we are certain the results will be terrible, and the stock will collapse. But the day before the earnings announcement, the broker that lent us the stock calls the shares back and we take a 40% loss ($8,000)… plus whatever margin interest we paid and any commissions. The next day, the stock collapses.
Not only are we in the hole $8,000, but we also missed out on a big profit. It isn’t right or fair, but it’s perfectly legal. It’s even happened to me.
The size of our potential losses is technically unlimited. When a stock falls, it can only fall to zero. But when a stock price goes up, the sky is the limit.
Short sellers of Tesla learned this painful lesson over the last couple of years. Tesla’s stock has soared more than 20x. Can you imagine losing multiples of the amount that you received selling shares short? That has to hurt.
This is why my general advice to investors is to avoid short selling entirely. There are simply too many dynamics that favor Wall Street.
There are, however, bearish ETFs and funds that we can buy if we think the market is going to drop. This greatly limits our downside even if our timing is wrong.
Options are another alternative. We can buy puts on stocks that we think are destined to fall. The most we can lose on a put is the cost of the option, which controls our downside.
All this leads me back to the excitement of GameStop and how Wall Street sold short the stock.
Unlike what I outlined above – legal short selling – this was “naked” short selling. The brokers lent out shares of stock that didn’t exist. It should be impossible, but it happens all the time. And it typically results in large price distortions that favor Wall Street and hedge funds.
GameStop was an exception.
Winning Wall Street’s Game
And now, WallStreetBets has 8.4 million followers.
As a result of the GameStop run-up, Citron Research, a firm that has profited off of short selling for the last two decades, got taken out to the woodshed on the GameStop trade.
Firms like Citron quietly establish short positions at the best prices and then publish damning research on the company. They make TV appearances and try to drive the stock down. But Citron got burnt so badly on GameStop that it announced it will discontinue publishing short selling research.
The game is up.
Hedge funds now know that grossly distorted short positions will be recognized by groups of retail investors who can cause a short squeeze in a matter of days or hours… with the potential loss of billions for the funds.
Now, investment banks like Jefferies and Wells Fargo are even publishing lists of companies that are heavily shorted and are candidates for short squeezes.
That’s exactly how free markets should work.
And one last note before I leave you today…
Don’t forget to join me for my Investment Accelerator event taking place TONIGHT at 8 p.m. ET.
At the event, I’m going to bring viewers up to speed on what I believe is my most ambitious project to date. We’re going to talk about a rare opportunity to join a top-tier group of investors for the chance to share in $1 billion in tech profits.
I’ll also share what I’m most excited about right now. And I’ll outline what I see as the five best investment opportunities that could return 10x our money over the next five years.
I know the world and the markets seem chaotic right now. Many people are worried about the future.
But I’m not one of them.
While I acknowledge the problems as I see them – as regular readers well know – I see immense opportunity in a number of areas right now.
In fact, all the uncertainty that’s prevalent today is creating the perfect climate for tech-savvy investors. Those who can tune out the day-to-day noise and focus on the big picture will do very well in the years to come.
And that’s what my Investment Accelerator event is all about. Right now the market is giving us a tremendous opportunity to turbocharge our investment returns. Let’s make sure we take advantage of it.
So please join me this evening at 8 p.m. ET sharp. We have a big night planned.
Editor, The Bleeding Edge