The world of investing is a big place. There's a lot to know and many, many strategies that investors use intending to make money. One strategy that's received a lot of attention lately is shorting stocks. Even people who don't follow investing news will probably have heard something about the short squeeze with Gamestop and AMC. So, what does shorting stocks mean, and how does shorting stocks work?
Shorting stocks is an investment strategy that investors use to profit from a potential downside in stock prices. An investor will open a margin account, borrow shares they believe will decline in value, and sell them for the market price. The idea is that, once the shares fall in value, the investor will buy them back, return them to the broker, and pocket any profit made. Let's look at an example now that we know shorting stock's meaning.
An investor might think the shares of Company 123, which are currently selling for $40 per share, will decline soon. The investor borrows 1,000 shares of Company 123 from a broker and sells them for the market price of $40, receiving $4,000. The market price of Company 123 goes down to $25, and the investor repurchases them for $2,500. The investor then returns the borrowed shares to the broker and keeps the profit of $1,500 less any fees. In this example, the profit before fees and expense is calculated like this: $4,000-$2,500=$1,500.
There really is only one reason investors short stocks: to make money. Three main underlying reasons support this motive:
Investment strategies usually have the potential for profit but also for loss due to the unpredictable nature of market volatility. Some strategies are riskier than others. Shorting stocks is considered a high-risk strategy that’s best left for experienced investors. The main risks of shorting stocks are:
In early 2021, a group of investors on Reddit decided to rapidly purchase shares in GameStop and AMC. By following investment news,these investors knew that each company had been significantly shorted by hedge funds, so they bought as many available shares as possible in order to drive up the price of the stock. Due to this, the share prices of both companies increased exponentially in a short amount of time. Gamestop increased by 864% and AMC by 388% by March 29, 2021, on a year-to-date basis.
Rising share prices left those who were shorting the stock trying to repurchase it as quickly as possible, which, in turn, increased the price even further. Many investors who intended to short the stock suffered incredible losses from this short squeeze. The benefit to those who bought the stock to force a short squeeze is that they had the opportunity to make an incredible profit.
One important thing to note about this situation is that many experienced investors were shorting GameStop and AMC for the most part, and they still took a significant loss.
Now that you know what shorting is and why investors use it, you might be considering it for your portfolio. However, we have seen that shorting stocks can be a high-risk, complicated strategy best left to experienced investors. Knowledge and experience are essential before trying to use this for your portfolio.
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