What it is, why it is risky and how a “tightening” happens

You may have heard so far that an army of retail investors has managed to use one of the hedge funds’ joint investment strategies against them.

That is, missing sales. It generally involves selling the borrowed shares of a stock with the belief that the price will go down, at which point you would buy shares at a lower price to repay what you borrowed (below). And it’s not just hedge funds or other large investment entities. Individual investors – for better or worse – can also hire him if their brokerage approves.

“For my clients who want to cut inventory, I tell them it’s generally not a good idea,” said certified financial planner Ivory Johnson, founder of Delancey Wealth Management in Washington.

More from personal finance:
Here’s a decade-long guide to retirement planning
Why be careful before investing in cryptocurrencies
Here is a 12-month roadmap to financial well-being

Retail investors, led by those on the WallStreetBets Reddit chat room, piled on Gamestop, AMC Entertainment and other stocks on which hedge funds relied on the decline.

In short: all purchases have raised prices, which means that fund bets have been wrong and lost billions of dollars. So far, for GameStop short sellers alone, the loss is at least $ 5 billion, according to S3 Research.

“These investors have access to information, they know which companies are very short-circuited and they communicate with each other,” Johnson said. “I wouldn’t be surprised if he keeps doing it … it’s like Occupy Wall Street Part 2.”

While this group demonstrates how retail investors can reach hedge funds where it hurts, the ongoing battle also shows how risky short selling is.

Usually, you buy stocks with the idea that they will increase in price and you will make a profit when you sell them.

In the case of short selling, the ultimate goal is still a profit. However, the transaction is based on your opinion that the stock is overvalued and therefore will lower the price.

The general process: borrow shares from the brokerage and sell them at the current market price (which, again, you think will decrease). Ideally, your vision is correct, and when the price has dropped, you buy shares at that lower cost to repay those you borrowed. Simplified illustration: shorten your stock by $ 7. It slips in price and you buy it for $ 2. Your profit is $ 5.

However, if the price goes up, at some point you should complete the transaction – that is, you should buy those shares to repay the brokerage. So if the $ 7 stock starts to rise and you sell it at $ 10 to cover your short position, you lose $ 3.

“Most investors think the risk is just downside,” said CFP Matt Canine, a senior wealth strategist at East Paces Group in Atlanta. “When you buy a direct stock, your losses are over – if you buy at $ 100 and it reaches zero, you lose $ 100.

“But if you shorten it to $ 200, $ 300, $ 400 and so on, your losses are aggravated,” Canine said. “The risk of growth is unlimited.”

When a stock is very short-circuited and investors buy stocks – which pushes the price up – short sellers start buying to hedge their position and minimize losses as the price continues to rise.

This can create a “short squeeze”: short sellers continue to buy stocks, pushing the price up even higher. (That’s what happened to the short-term stocks targeted by the crowd of Reddit investors).

Generally, you can only engage in short sales using a margin account. This is essentially a brokerage loan, which will charge you interest and require you to maintain a certain level of funds in that account.

When the value falls below that threshold, your brokerage will ask you to complete the account. Your brokerage may also ask you to hedge your short position when the price has risen.

As for how the saga of Reddit vs. Investors ends. hedge funds?

“Some people will make a lot of money,” Johnson told Delancey Wealth Management. “But there will be people who … come in and lose their shirts.”