A word about short selling: Don’t

The fracas in January over GameStop suddenly brought the practice of shorting stocks back into the public spotlight.

When you sell short, you sell something you don’t actually have. You are short, in this case, of shares of stock, so you borrow them from someone who owns them. The short seller then takes these shares and immediately sells them into the market to someone else. The objective is to buy the shares back later at a lower price and return them to the person from whom the seller borrowed them in the first place.

Imagine, for example, that you sell 100 CocaCola shares short at $50 a share. Through your broker, you ask to borrow

100 shares from a current stockholder. You sell them the same day and pocket

$5,000. A month later, the stock has dropped to $44.

You pay $4,400 for those shares and return them to the original lender. Your profit is $600, minus commissions for buying and selling and minus interest on the loan of the shares.

The internal mechanics are complicated, but for the investor it’s all simple: Short the stock. If it goes down, you make money. If it goes up, you lose. It’s the opposite of buying a stock, so the risk is similar, right? Wrong. When you buy a stock, the worst thing that can happen is it goes to zero and you lose what you invested.

But with a short, you can lose much more.

Say you shorted 100 shares of GameStop when it was $20 a share and it goes up to $300. You borrow the shares and sell them, pocketing $2,000. But within a few weeks, it will cost you $30,000 to buy the shares you need to give back to the lender. In the meantime, your broker has been calling you to put up margin — or collateral — to ensure that you eventually have the money to supply the stock to the lender. As the price of the stock rises, you have to put up more and more margin.

Now, consider an investor, such as a hedge fund, that has shorted not 100 but 1 million shares of GameStop. A $20 million investment suddenly becomes a $300 million liability. As the stock price rises, such an investor may want to close out his position — that is, buy 1 million shares. But those shares are not easy to find — in part because so many other investors hold short positions and are in the same boat. In order to find enough shares, the investor has to bid up the price. This is called a short squeeze, and it’s a terror to behold if you’re the one who is short.

Resist shorting. If you pick a bundle of stocks at random and buy them, history shows you will earn a return of 10% a year. If you short stocks at random, you will lose that much, plus borrowing costs.

DREAMSTIME