As I mentioned in a recent piece, I think Facedrive (TSXV:FD) is perhaps the best short opportunity in Canada right now. Since this piece was published on Feb. 22, shares are down more than 30% at the time of writing. For short-sellers, that’s a nice quick +30% profit in a couple weeks.
I think this stock has a long way to fall, and this is only the beginning. I’d encourage investors to read my previous piece for more information on why that’s the case.
In this article, I’m going to describe for new investors what short-selling is, and how one can get involved, if they so choose.
How to short-sell a stock
Selling a stock short has been made quite simple these days. Most brokerage firms offer the option of “sell short” in the drop-down menu where “buy” or “sell” are listed.
Short-selling is a strategy used by investors looking to bet against a stock. Essentially, the short-seller borrows the stock they don’t like and sells it at the (hopefully overvalued) market price. The short-seller promises to return the borrowed stock and pays a premium to the lender (owner of the stock). The brokerage firm orchestrating the trade also gets a cut. It’s a win-win-win scenario where all three parties benefit from the transaction.
If the price drops as the short-seller hopes, they buy the stock back at the lower market price at a profit. If the stock goes up, however, such an investor could be saddled with a large loss. This makes short-selling inherently risky and only a strategy that is typically used by sophisticated investors.
When one feels like most of the downside has been captured with a given stock, it’s time to “cover” one’s position. What does this mean? It means an investor will buy back the stock they borrowed at the market price and keep the difference (the hopeful profit).
The risks to short-selling are high, so trade carefully
Unlike buying a stock, which carries a potential loss of 100% (if the stock goes to zero), options carry unlimited risk.
This is because stocks can theoretically go up to infinity, so the potential losses for the short-seller are infinite. As mentioned, short-selling is typically used by sophisticated investors with very high bearish conviction on a stock.
Indeed, I think this could be the most overpriced stock in the universe right now. I can’t find a company that comes close to the absurdness of this valuation. Accordingly, Facedrive finds itself in my high-conviction bearish bucket of stocks right now.
However, the potential downside risk for short-sellers is that, as Keynes said, “the market can stay irrational longer than you can stay solvent.” In other words, if an angry mob of retail investors decides to pick on Facedrive, the stock could go berserk again.
Facedrive is an interesting short opportunity for sure, and I think is almost certainly likely to go down significantly from here. But the market’s crazy right now, and investors are doing crazy things.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Chris MacDonald has no position in any of the stocks mentioned.