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Tuesday, March 5, 2024

Short selling: What it is, why it’s risky and how the ‘squeeze’ happens

  • In basic terms, short selling involves counting on a stock price dropping.
  • So far in 2021, GameStop short sellers have lost at least $5 billion, according to S3 Research.
  • With the strategy, the risk on the upside is unlimited.

Aimee Dilger | SOPA Images | LightRocket | Getty Images

Maybe you've heard by now that an army of retail investors has managed to use one of hedge funds' common investment strategies against them.

That is, short-selling. It generally involves selling borrowed shares of a stock with the belief that the price will drop, at which point you'd buy shares at a lower price to repay what you borrowed (more farther below). And it's not the province of just hedge funds or other large investment entities. Individual investors — for better or worse — can employ it, too, if their brokerage approves it.

"For my clients who want to short stocks, I tell them it's generally 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, have been piling into Gamestop, AMC Entertainment and other stocks that hedge funds were counting on going lower.

In a nutshell: All the buying pushed up the prices, meaning the funds' bets were wrong and they've lost billions of dollars. Year to date, for the GameStop short sellers alone, the loss is at least $5 billion, according to S3 Research.

"These investors have access to information, they know which companies are heavily shorted and they're communicating 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 is demonstrating how retail investors can hit hedge funds where it hurts, the ongoing battle also shows how risky short selling is.

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