What is short selling a stock?

As Jules and I fantasize about where to retire, we have learned that there are lake people and there are beach people. I recommend marrying someone in the same category… Lake Life > Beach Life. Don’t @ me, Jules.

Short selling a stock is when you sell a stock you don’t own then buy it at a later date. This confusing reversal is a way to profit when a stock loses value. Short selling carries UNLIMITED risk with limited reward.

To sell a stock you don’t own, you first have to borrow the stock. Typically, that comes from your brokerage firm (Schwab, Fidelity, etc.). If you are borrowing the stock, you are not getting it for free. You will be on margin. If you don’t know what that means, check out our previous newsletter! The margin loan will require you to make interest payments. 

Additionally, if the borrowed stocks receive a dividend payment, the original owner will not receive that payment since the stocks were sold to a new owner. However, the original owner is still entitled to those dividend payments. You, as the short seller, will have to pay the original owner the value of the dividend payment. Typically, this happens when you close the short position. 

The margin loan interest and dividend payments make short positions an increasingly complicated and risky investment.

So now you’ve borrowed the stock, sold the stock, and are anxiously watching the value and hoping it dives. Let’s run some numbers to demonstrate the UNLIMITED risk and limited reward I mentioned earlier:

Good Scenario:

• You short sell 100 shares of Boeing $BA at $190 - $19,000

• Another Boeing door flies off mid-flight *hypothetically (kind of)

• $BA nose dives to $100 per share

• You close your position (buy 100 shares) - $10,000

• Profit - $9,000 (minus margin interest and any dividend payments)

Maximum Reward Scenario:

• You short sell 100 shares of Boeing $BA at $190 - $19,000

• Another Boeing door flies off mid-flight *hypothetically 

• Another whistleblower dies in mysterious circumstances *hypothetically

• Boeing’s Starliner rocketship runs several years late and billions over budget

• Boeing is forced to slow down production to allow the FAA to inspect their planes

• Boeing’s main competitor (Airbus) is so overloaded with demand they are taking orders that won’t be delivered for years

• $BA nose dives to $0 per share

• You close your position (buy 100 shares) - $0

• Profit - $19,000 (minus margin interest and any dividend payments)

The maximum profit you can make from a short position is if the stock goes to $0. When you open your short position, you know your maximum profit. The value can only go to $0; it cannot go negative.

With a short position, you have to buy the shares off the market to return them to the lender. In theory, the value of the stock is unlimited, meaning your losses are also unlimited.

Bad Scenario:

• You short sell 100 shares of Yankee Candle $NWL (Newell Brands Inc is the parent company) at $7.37 - $737

• Yankee Candle announces a new candle, Ocean Thunder

• You buy it, smell it, and immediately realize you made a mistake 

• $NWL rises to $12 per share

• You close your position (buy 100 shares) - $1,200

• Loss - $463 (plus margin interest and any dividend payments)

Unlikely (but not impossible) Scenario:

• You short sell 100 shares of Yankee Candle $NWL at $7.37 - $737

• Yankee Candle announces a new candle and associated NFT, Ocean Thunder

• You take a three month darkness retreat and never check your portfolio

• $NWL rises to $10,000 per share

• You close your position (buy 100 shares) - $1,000,000

• Loss - $999,263 (plus margin interest and any dividend payments)

This scenario is extremely unlikely, but if NVIDIA has taught us anything this year, it's that a stock on a rally truly has no limits. Additionally, since you have a margin loan, you’ll likely experience a margin call long before you are $900,000 in the hole.

However, for the large hedge funds who play by different rules, a short position can be extremely dangerous especially when a bunch of redditors decide they’ve had enough. This is exactly what has happened with GameStop.

A bunch of hedge funds have short positions on a seemingly dying retailer that specializes in re-selling physical video games and paraphernalia. Their logic is pretty sound. Video games are increasingly transitioning to subscription services and downloaded purchases. GameStop’s overhead with brick and mortar stores plus being on the wrong side of a transitioning industry made them a prime stock to short. 

The hedge funds were correct for a while. Then came r/WallStreetBets, a Reddit forum where retail investors posted their picks, wins, and losses. A large group of retail investors, led by YouTuber Roaring Kitty, started buying the stock to cause a short squeeze.

A short squeeze is when a heavily shorted stock is purchased in large quantities. This causes the stock value to increase. If the stock increases enough, the investors with short positions start to lose money. Eventually, the short sellers have to close their position (by buying stock). This causes demand for the stock to increase even more, increasing the value. Causing more short sellers to close their position (by buying even more stock). The spiral continues and the short squeeze is in full effect. That is until Robinhood stops trading, the stock exchanges stop allowing trading, and the hedge funds wait until after hours to close their positions and minimize their losses (again, they don’t play by the same rules).

This group did succeed in causing a short squeeze for GameStop and AMC (also a heavily shorted stock) back in 2021 and just last month. Roaring Kitty at one point was over $600 MILLION in profit with his GameStop position. To the public’s knowledge, he hasn’t sold and is now back down to just over $200 million in profit. The hedge funds with short positions had $1.24 BILLION in losses with the newest rally.

All that to say, Mike and I think short selling is an interesting aspect of the stock market, but not one we recommend for any retail investors. Buy Index Funds/ETFs and wait. Unlimited gains is a way more exciting investment compared to unlimited losses (this is how I convince myself to not short sell Boeing).

What We’re Reading/Listening To:

Podcast - WSJ What’s News: Fed Projects One Rate Cut This Year Despite Mild Inflation Report. I don’t want to spoil this month’s debrief, but this podcast covers yesterday’s inflation data and the updated rate cut expectations. I wish I could say this update shocked me…

Debrief on Deck

Next week, Mike is going to talk about the different rules some people play by starting with Early and After Market Hours. The good news is when you buy and hold, you don’t think in hours. You think in years.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

Disclaimer