In the stock market, investors buy and sell shares in companies. Typically, you purchase shares first, then you sell them to another investor (hopefully at a profit). However, there is another technique that can be used to make money in the stock market, and it’s called shorting a stock.
Shorting a stock is when an investor sells shares of a company without owning them. Then, at a later date, the investor will purchase the shares and realize a profit (or loss). When an investor believes a stock will fall, they are “short” on the stock. Conversely, when an investor believes a stock will rise, they are “long” on the stock. These two terms are commonly used to describe the different positions investors take regarding stocks.
Let’s look at an example. Bob believes the price of XYZ Corporation stock will fall, so he takes a short position. Bob sells one share of XYZ Corporation at $100. Since Bob is selling a share he doesn’t own, he will have to purchase the share later on to cover his bet.
Over the next two months, XYZ Corporation stock falls to $80 per share. Since the stock’s current price is lower than the price Bob shorted it at, his investment is in the green, meaning he would make money if he closed his position. Bob decides that he will purchase the share at $80, effectively closing his short position. Bob will pocket the difference between the price he shorted the stock at ($100) and the price he purchased the stock at ($80), leaving him with $20 in profit. Not bad!
However, let’s say the price of XYZ Corporation stock rises to $130 per share. Since the stock’s price is higher than the price Bob shorted it at, his investment is in the red, meaning he would lose money if he closed his position. Bob decides that he will purchase the share at $130, effectively closing his short position. Bob will take a $30 loss on his bet because the price he purchased the stock at ($130) is higher than the price he sold it at ($100).
Sometimes, a short squeeze can occur when a stock is heavily shorted. A short squeeze happens when short investors rapidly try to purchase shares of a company to close their short positions. This can result in a massive stock price increase.
In early 2020, shares of GameStop (Ticker: GME) rose 1,200% from $17.25 to $325 in January as short investors rushed to purchase shares to cover their short position.
Shorting a stock is considered very risky as you’re selling stock that the don’t own with the obligation to purchase them later. As always, conduct thorough research before engaging in any investment!
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