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?

Key takeaways

• Investors short sell stocks by borrowing stocks from a broker, selling them at market value, and expecting to buy them back for a lower price.
• When shorted stocks decline in price, the investor profits from the difference between the price they sold the stock for and the price they paid to buy it back.
• The risks of shorting stocks are misreading the market, the potential of unlimited losses, and being caught in a short squeeze.

Shorting stocks explained

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.

Reasons investors short stocks

There really is only one reason investors short stocks: to make money. Three main underlying reasons support this motive:

1. They believe the value of a particular stock will decline, and shorting the stock will generate a quick profit. This belief could be based on financial information about the company, market conditions, or knowledge of an industry. If, for example, they believe a company will be releasing poor financial reports for the quarter, they may think this will drive the stock price down. Another example is a drug company that might be trying to get a patent, and, if it doesn't, its share price could go down.
2. The investor feels the market as a whole is going to suffer a loss. If the stock market turns into a bear market, most stocks will decline in value. The purpose of shorting stocks in this case is to take advantage of a market downturn to make a profit.
3. Investors can use shorting stocks to hedge a long position in another asset. This means the investor has an investment they want to hold onto for a long time. They feel reasonably confident that the investment will increase in price, but they're not 100% sure. To offset any potential loss of the asset they want to keep, they may try shorting stocks to make a profit. The profit on shorting the stock  is used to offset any potential loss on the investment they plan to keep.

Shorting stock risks

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:

1. The price of the stock will go up instead of down. An increased or inflated stock price will cause a loss for the investor. If the investor sold 1,000 shares of borrowed stocks for $40 but has to repurchase them at $80, they will lose $4,000.
2. The loss an investor can incur when shorting stocks is limitless because there is no limit to how much a shorted stock might increase in value. It could stay at the same price, double, triple, or increase in value. The  investor shorting stocks will have to pay the market price to buy back the stocks, regardless of the stocks’ price. Buying stocks with cash, however, limits the investor's loss to the amount they paid for the stock. If 100 shares of a company are purchased for $25, the most the investor can lose is $2,500.
3. The investor might not be able to buy back the stocks they sold. If the stock is holding its value or increasing its value, investors who have them may not sell them. If too many people try to short the stock, there may not be enough shares available for sale for the investor shorting the stock to buy and return to the broker. This scenario is called a short squeeze. In either case, investors shorting the stock are almost certain to suffer a loss.

Case in point: GameStop and AMC

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.

Shorting stocks takes knowledge and experience

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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