Everything you ever wondered about short selling stocks

With many people now using online brokerage accounts that let the average person buy and sell stocks from the basement sofa, financial lingo has never been so common. The popularity of films like “The Big Short” also demonstrate how mainstream complex financial workings have become.

But having a passing familiarity isn’t the same as truly understanding something, and pressing “buy” on a few dozen Scotiabank shares does not make one a markets expert. Blurt out the term “short selling” at a cocktail party, and you’ll probably receive a slow nod that tells you, ‘yeah, I’ve heard of that’ (because we all saw the “The Big Short”).

But what does short selling really mean?

Simply put, it means investing with the expectation that the value of a certain security will fall, rather than rise, and the goal of profiting from that fall. But ‘shorting’ something is considerably more complex than ‘going long’, or betting that a security will rise, says Kathryn Del Greco, Vice President and Investment Advisor at TD Wealth.

“This is a strategy not for the faint of heart, nor for a beginner investor. This is not something that you … walk away from and don’t monitor,” she says.

So why do this? Hedge fund managers like it as a sort of insurance for all the long investments they make. But other investors will simply short a stock (or ETF or some other security) because they think it’s on the verge of a fall. This happens particularly when investors smell a ‘bubble’ or an unjustified rise in the market, but also if the investor sees flaws or structural problems in the company that haven’t yet been appreciated by the market.

You can track how many short bets are on a particular stock through “short interest” data.

Last week, the Globe & Mail reported that Calgary-based Boardwalk Real Estate Investment Trust is the most shorted company in North America, with short interest covering 37 per cent of its outstanding shares.

Basically, this means that investors (possibly U.S. hedge funds) have borrowed and sold more than a third of the REIT’s outstanding shares, betting that the stock will plunge, likely as part of a broader crash in the Canadian housing market (sound familiar, “Big Short” fans?).

But it’s one thing for hedge funds to play in this game, and another thing for armchair investors looking to profit from a stock selloff.

“This is generally something done by sophisticated investors who are watching the market very very closely and understand the risks that they’re walking into,” says Del Greco.

The trick with shorting stocks is the potential for massive loss.

Think about a typical stock investment, where you buy $10,000 worth of shares expecting them to rise. If they don’t, the most you’re risking is $10,000, and it’s unlikely the stock would ever fall to zero. More likely, you’re risking a small to moderate piece of your original investment.

But with a short, you take losses when the stock rises, and that’s where the math gets tricky.

“There is no ceiling on how much a short seller can actually lose on a trade, because the stock can theoretically go (up forever),” says Del Greco.

So, let’s say instead of buying those shares, you think they’re primed for a sharp fall, and decide to short them instead.

You borrow $10,000 worth and sell them, planning to buy them back at a lower price. But instead of falling, they rise. You figure this is just a temporary situation and decided to wait it out, but they keep rising. Meanwhile, the broker that you borrowed the shares from is demanding that you put more money in your account (margin calls) as insurance against the possibility that the stock keeps rising. Finally, you cry uncle and buy back the shares at $20,000, returning them to the lender, and taking a loss of $10,000 plus the fees.

And this is a conservative example. Shorting a volatile stock can lead to sharp swings in the wrong direction, leaving investors on the hook for multiples more than their original investment.

Ultimately, that brokerage account can be empowering by allowing retail investors to make their own decisions. But just remember that the guys in “The Big Short” lost millions before they made billions.

“You may think you are right in your assessment that the shares might decline, but it may not happen in the time frame that you think,” says Del Greco.