Shorting: how to do it like a hedge fund

‘Shorting’ has become the talk of the town, following the GameStop share-buying story. But what does shorting really mean, and why might it have value, rather than being seen as an attempt by ‘robbing’ hedge funds to ruin a business?

A recent tweet from Elon Musk got a lot of attention:

u can’t sell houses you don’t own, u can’t sell cars u don’t own, but u can sell stock u don’t own!”

And that, in brief, describes shorting. It stems from the fact that there are always some stocks that are of “short interest”, which is finance-speak for stocks that investors believe will go down in price in the future. That’s what certain hedge funds thought about GameStop.

It may seem odd to those of us who think in terms of investing in stocks in the hope the value will go up. Shorting is just the opposite: using this method investors attempt to profit from a stock’s price going down instead of up. As Rob Isbitts says in a recent Forbes article: “short selling is to investing what sword-swallowers are to entertainers: it is way, way at the high end of the riskiness spectrum.” So, it’s not something to try at home, in other words.

How do investors ‘short sell’ stock?

It’s definitely more complicated than buying a stock and then selling it. That’s the easy option.

The thing to remember is that the stock market revolves around ‘valuing’ a business. A business launches a new product that proves popular, and its share value rises. That’s what most investors look for: a company that is producing something which is perceived as valuable. Short sellers have a very different approach.

As Isbitts’ says: “They look for businesses that the market thinks too highly of. In other words, businesses that are, in their judgement, “overvalued.”

Hedge funds and others are always analysing markets, and often they are looking for stock selling at a higher price than they believe it is worth. Now, if they buy that stock there is no way that they can make a profit from their ‘buy’, because they predict it will be going down. However, their research has shown them an opportunity to sell the stock short.

In order to do this, they ‘borrow’ shares of the company they want to short from a broker. These shares are then owed to the broker at some point in the future. When they return them, they receive the profits of the short sale. Isbitts sums it up neatly: “If the stock price goes down, those same shares will be worth less than the short seller received. That allows them to repay those shares to the broker, but pay less to do so than they received when they shorted.”

There is of course a lot of risk involved in doing this, as a few hedge funds found out after the r/WallStreetBets community pushed the share value of GameStop up.

If you invest $5000 in shares priced $50, the most you can lose is $5000. But if you enter into a short on stock that is valued at $50 per share, and the share price rises to $500, then you owe the stock back to the broker at the new price of $500, not the $50 you shorted it at. In other words, you have lost a lot of money, because you never owned the stock in the first place.

The hedge funds believed that GameStop’s share price would fall, and so initiated short sale trades, but got caught out by a large group of retail investors who followed the crowd.

Whatever Elon Musk might say, shorting is not a scam: it’s an investment position, largely based on research and opinion about a company. What happened with GameStop is not necessarily good news for the small guy. They may go searching for other companies that have been heavily shorted and attempt to repeat their GameStop action. But tracking down overvalued businesses in a bid to make money could really bite them on the ass. This has been a particularly crazy episode, and it appears the subredditors have turned their attention to silver this week. Let’s hope that in this case ‘every cloud does indeed have a silver lining’.

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