Musical shares: The long and short of short selling

For a month or so now, the news has highlighted something called short selling. This has been due to actions from a Reddit group who chose to manipulate the share price of a number of companies (GameStop among them) to hurt a number of hedge funds.

To be very blunt about it, short selling is NOT a form of investing. It is a form of gambling, no different than a card game or rolling the dice in Vegas. The difference between investing and gambling may not always be easily discerned, but there are clear differences. I’ve written about this before: investing is by its very nature long-term, gambling is short-term. When we gamble, we hope to win at someone else’s expense. When we invest, we are hoping our investment will produce dividends and accrete value, but not usually at the expense of another. 

Short selling is the practice of selling shares that you don’t own. You borrow them, sell them, and hope that you can buy them back later at a lower price. For example, hedge funds may have thought that GameStop was grossly overvalued at $5 per share. Imagine for a moment that you hoped to make $10,000 by short selling GameStop. You would borrow 2,000 shares and sell them for $5 per share netting $10,000. But don’t forget, you owe somebody those 2,000 shares so you will have to buy them back at some point to return them.

As a point of practicality, brokerage firms require that you keep a large safety buffer when short selling, often 3 times the value of the shares. In this example you would have to either hold $30,000 in cash with the firm or show that you are good for it and pay them interest on it, effectively being forced to borrow $30,000 from them.

If GameStop’s share price was to go to zero, you would get your 2,000 shares for free, return them to the owner and now you’ve made $10,000. Your potential gain is limited to the $10,000 as share prices do not go below zero. Your risk, however, is unlimited. In this instance the share price rose. 

Remember that the brokerage house doesn’t ever want to be at risk, so they will always demand that you hold a significant buffer. When the share price doubles, they will want double the security, so you will need to come up with another $30,000 in collateral. In fact, in this instance, the share price went up to an intra-day high of close to $500. If you had indeed shorted 2,000 shares of GameStop at $5, the brokerage firm would now be demanding that you to put up $3,000,000 in collateral. Your other option would be to buy back the position so you could return the shares you had borrowed, but now to give back those 2,000 shares, you have to pay $500 per share so it would cost you a cool $1 million.  All that in an effort to earn a maximum of $10,000!

Even if you’re into gambling, that’s a big risk. And that’s exactly what happened to the large hedge funds. Billions were lost.

Normally short selling is risky, but not quite this risky. This situation came about due to market manipulation. At this point it doesn’t appear that there was any dishonesty. The manipulators seemed to be up-front about their intentions, but the fact remains that there was a very clear temporary manipulation of the shares of a number of securities. And furthermore, there was a targeting of a certain group of investors: hedge funds. It is for precisely that reason that we are seeing legal action against the market manipulators. 

At the end of the day, my advice is to avoid any and all of the above. If you want to invest, then invest. Think long term. Do research (or pay someone to do it for you). Have your investments grow because you own pieces of great companies that grow, not because of the bigger fool model that says, “I don’t know what this company is worth, but I’m going to buy it today because some bigger fool will buy it later for more.”

I am not a particular fan of short selling for reasons noted above, but I wouldn’t absolutely rule it out as an option in some unique particular circumstances. Market manipulation, on the other hand, trumps gambling as bad behaviour, at least in my opinion, and should never be tolerated. 

Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area where he attends Gracepoint Community Church.  He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services.  Questions and comments can be directed to him at dr.rrsp@visionvest.ca or through his website at www.visionvest.ca.  Please note that all comments are of a general nature and should not be relied upon as individual advice.  The views and opinions expressed in this commentary are those of Arnold Machel and may not necessarily reflect those of IPC Investment Corporation.   While every attempt is made to ensure accuracy, facts and figures are not guaranteed. 

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