What is it, why is it risky and how a “ squeeze ” occurs

You may have already heard that an army of retail investors have successfully used one of the common investment strategies of hedge funds against them.

In other words, the short sale. Usually this involves selling borrowed stocks of a stock with the belief that the price will go down, in which case you would buy stocks at a lower price to pay off what you borrowed (further below). And it’s not just the province of hedge funds or other large investment entities. Individual investors – for better or for worse – can also use it if their brokerage approves it.

“For my clients who want to sell stocks short, I tell them that is usually not a good idea,” said certified financial planner Ivory Johnson, founder of Delancey Wealth Management in Washington.

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Retail investors, led by those in the WallStreetBets Reddit chat room, piled on Gamestop, AMC Entertainment and other stocks that hedge funds were counting on declining.

In a nutshell: All the buying drove the prices up, which meant that the funds bets were wrong and they lost billions of dollars. Since the start of the year, for GameStop short sellers alone, the loss has been at least $ 5 billion, according to S3 Research.

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

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

Typically, you buy stocks with the idea that their price will go up and you will make a profit when you sell them.

With short selling, the end goal is always a profit. Yet the trade is based on your opinion that the stock is overvalued and therefore its price will drop.

The general process: You borrow stocks from your brokerage firm and sell them at the current market price (which, again, you think will go down). Ideally, your opinion is correct, and when the price has gone down, you buy stocks at that lower cost to pay off the ones you borrowed. A simplified illustration: you sell a stock for $ 7. Its price slips and you buy it at $ 2. Your profit is $ 5.

However, if the price increases, at some point you will still need to complete the trade – that is, you will need to buy that stock to pay off the brokerage. So if that $ 7 stock starts going up and you sell it for $ 10 to cover your short position, you’ve lost $ 3.

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

“But if you sell it short and it goes down to $ 200, $ 300, $ 400, etc., your losses are compounded,” Canine said. “The upside risk is limitless.”

When a stock is sold heavily and investors buy stocks – which drives up the price – 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 have to buy the stocks, pushing the price higher and higher. (This is what happened with short stocks targeted by the Reddit investor crowd).

Generally speaking, you can only engage in short selling using a margin account. This is basically a loan from your brokerage house, which will charge you interest and require you to maintain a certain level of funds in this account.

When the value drops below this threshold, your brokerage will ask you to replenish the account. Your brokerage firm may also ask you to cover your short position when the price has increased.

As for how does the saga of Reddit investors against hedge funds end?

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