Despite being glamorized in such books as Michael Lewis’s The Big Short, short selling has always been Wall Street’s most dangerous game. During the 2008–2009 financial collapse, it appeared easy to make money by selling stocks short—meaning betting on their decline. Those who did so after 2009, however, quickly learned the bitter downside: as stocks recovered, money vanished.
Whenever I hear about short selling, I remember the 1924 story “The Most Dangerous Game,” Richard Connell’s wryly ironic tale about a big-game hunter who washes up on a deserted island, only to be hunted himself by a Russian aristocrat. That a hunter can instantaneously become prey is no surprise to anyone who understands the machinations of stock trading, but it still always seems to shock those hedge funds that take the bait of shorting an overvalued stock.
The Gamestop GME -60% (#GME) saga, Wall Street’s best attempt at a thriller, highlights the way in which hedge fund hunters find themselves running for cover. To understand how this works, you have to understand the way a “short squeeze” (the way in which short sellers become the victims of their own actions) works.
The method by which a short seller shorts a stock is as follows: Let’s take hedge fund XYZ. Say they want to short shares of ABC Corp, which they believe are overvalued. To do so, XYZ first borrows shares of ABC from their broker. They immediately sell those shares and pocket the cash. Assuming XYZ shorted ten shares of ABC at $10/share, XYZ would now hold $100 cash after borrowing and then selling the stock. It may sound nonsensical that someone could sell something that they’d borrowed. But since shares of stock are interchangeable, this is done all the time. Fund XYZ can easily sell the borrowed shares as long as they agree to pay back the shares at a later date. Since one share of stock in any given company is exactly the same as any other share of stock in the same company, XYZ can buy different (but identical) shares of ABC at a later date to pay off this loan of shares that they owe.
Going back to our example, once XYZ borrows and sells the shares, it now owns $100 in cash and owes 10 shares of XYZ. So how does XYZ intend to make money? It can make a fortune if ABC’s stock price collapses. If, for example, ABC’s stock were to fall in price to $5/share, XYZ would buy back the shares at that price and immediately return them to the broker. Now, having closed out its position and paid back its debt, XYZ no longer owes or owns any shares of ABC. But since they only needed $50 to buy back the stock (10 shares at $5/share), they get to keep the remaining $50, a tidy profit.
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But the danger in shorting becomes apparent if ABC stock had gone up in price, not down. For example, if ABC went up to $20/share, XYZ has a big problem that might easily get bigger. Remember that they owe 10 shares of stock to their broker. As the shares rise in price, they are still responsible for paying back those shares. Given that the shares are now at $20 each, it will cost XYZ $200 ($20/share times 10 shares) to buy back the stock and return it to the broker. They have now lost $100 on their original $100. Given that stocks can theoretically go up to any price, including infinity, the losses are potentially unlimited. Let’s imagine that ABC stock goes up to $1000/share (not impossible). Now XYZ must come up with $10,000 to buy back the shares and close out the position—a gargantuan loss of $9,900 on a $100 trade. Fund XYZ may not even have the $9,900, in which case they are now defunct, wiped out by a stock going up exponentially in price.
A short squeeze occurs when a large number of short sellers all try to buy back stock at the same time, thus further boosting the price of the very shares they need to go down in price. This becomes a vicious circle of ruin whereby funds buy back stock, causing the price to go up, which in turn causes other funds to buy back stock, which causes the price to go up again, thus causing colossal losses for the short sellers.
If this cautionary tale hasn’t dissuaded you from shorting stock, nothing will. Just remember that when you short a share, you may go from hunter to hunted in a Wall Street second.