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What Is “Short-Selling?” And How Does a “Short Squeeze” Work? Here Are the Answers

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All this talk about the Reddit “WallStreetBets” (WSB) mob that has driven the stock prices of companies like BlackBerry higher in a parabolic way. What the heck is “short-selling?” Furthermore, what in God’s name is a “short squeeze?”

I’m going to take a look at these two absolutely intriguing phenomena. These are mostly theoretical concepts thrown around in MBA classrooms. Listening to a professor drone on about how these theoretical concepts could work and seeing it happen are two different things. Personally, it’s been very exhilarating to watch the action from the sidelines recently. Let’s dive into what these market phenomena are.

Short-selling 101

“Short-selling” is a common way investors can bet against a stock. Investors make money when a shorted stock decreases in value. It’s the opposite of taking a “long” position (or just buying stock and benefiting from its increase).

Essentially, investors borrow shares they don’t own and sell them on the open market. These investors get proceeds from the transaction they can then use to buy other stocks. They just have to agree to replace the shares at a later date and pay a (usually) small fee to borrow the shares from the brokerage firm holding them for other parties. Not a bad deal, right?

Everyone wins. The investor can bet against a stock they don’t like and actually take those funds and invest them in good companies. The brokerage firm and owner of the borrowed stock both make some money on allowing for the shares to be borrowed. In a normally functioning market, long positions and short positions usually find some sort of equilibrium. Some people are bullish on a stock and others are bearish. Allowing bearish folks to short stocks is widely accepted to be a good thing in terms of allowing for price efficiency in markets.

Short squeeze 101

There are some risks to shorting a stock. A long position has a maximum loss of 100% (if a stock goes to zero). However, a short position has potentially unlimited losses. This is because investors who short a company will have to replace the stock in the future at the market price. In theory, since stocks can increase to infinity, these losses are uncapped. There’s no telling how big of a loss a short-seller could take on a stock.

In some cases, short-sellers can get squeezed out of a position and be forced to buy back shares at the market price. This typically happens if their losses exceed the minimum threshold a brokerage firm will allow. For example, consider a short-seller with assets of $100 million and an average margin requirement of 50%. If a short-seller loses more than $50 million on a short trade, a margin call can be undertaken by the brokerage firm holding this investor’s equities. This will force the short-seller to “cover” his position (buy back the borrowed stock he sold) and/or sell stocks to make up for the loss.

Most of the time, those who short stocks know what they’re doing. Since the risk is so high with this trade, short-sellers tend to be of the hedge fund variety. Indeed, short-selling can be very profitable, if an individual or fund can pick stocks they think will perform really poorly. Many hedge funds are short-oriented. They focus on companies they consider to be non-investment grade, short them, and rake in the profits when these stocks fall. These hedge funds make money when other investors lose. These hedge funds also have the potential to push stock prices of hot stocks retail investors like down. This is where the WSB mob comes into play.

The WSB mob has openly discussed “squeezing” these short-sellers out of their position. Those on the Reddit group don’t like the influence these hedge funds and short-selling firms have on stock prices. They don’t like that some people are making money when others are losing everything. Furthermore, they really don’t like it when some hedge funds have gotten bailed out in the past for their risky downside bets.

In many ways, this is being viewed as a “David vs. Goliath” type of movement. Who will win at the end of the day is unknown. However, with some brokerage firms limiting the purchase of these stocks in the U.S. and Canada, we could see regulatory enforcement come into play in a big way soon. Regulators don’t tend to like market manipulation of any kind. Shorting a stock isn’t illegal and is, in fact, encouraged. Short squeezes are more grey area.

These stocks that have been squeezed have gone absolutely parabolic of late! Here are some top "long" positions I think could go parabolic as well!

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Fool contributor Chris MacDonald has no position in any of the stocks mentioned. The Motley Fool recommends BlackBerry and BlackBerry.

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