When it comes to profiting off the stock market, most Canadians make money when the price of stocks go up. But quite a few try to short sell and make money when the value of stocks goes down. How does short selling work, and is it worth the risks involved?
Here’s what Canadian investors should know about shorting a stock.
What is shorting a stock?
When investors short a stock, they borrow shares from other investors, sell them at the current price, and buy them back later when the price of the stock has gone down.
In short, shorting a stock is a bearish position. You’re essentially selling high in the hopes that a stock’s value will go down, then buy it low. This is the opposite of the traditional investor, who holds a long position and bets that the value of a stock will go up over time.
For example, let’s say you believe Stock A is overvalued at $100 per share. You believe in a short time the price of Stock A will plummet. So, you find an investor through your brokerage who is willing to lend you 100 shares of Stock A.
After you sell the 100 shares, you’re left with $10,000, along with an obligation to return the 100 shares to their original investor at some point in the future.
Now, let’s say that after a month, Stock A’s price falls to $50 a share. At this point, you’re in a lucrative position, so you buy 100 shares of Stock A for $50 per share, or $5,000 total. After you return the original 100 shares to their rightful owner, you get to pocket $5,000 ($10,000 – $5,000) — less any commission or transaction fees.
What are the risks of short selling?
Shorting a stock could bring you some hefty short-term gains. But it’s a dangerous game to play. Here are some risks to short selling that you should be aware of.
1. Losses are unlimited
Normally, when you buy stocks, you have unlimited profit potential with limited losses. At the most, you’ll suffer a complete loss, meaning your stocks will go to zero, and you’ll lose whatever you originally invested. But if your stocks’ values soar, you don’t have to worry about a cap on how much you earn.
With short selling, the opposite is true. Your gains are capped, and your losses are unlimited.
Let’s look at Stock A again. You borrow 100 shares of Stock A and sell them for $100 per share. You have $10,000 in your brokerage account, and you wait until the prices go down to repurchase the shares. In this scenario, the most you could ever make happens when the value of Stock A hits zero (Company A goes bankrupt). In that rare event, you could buy 100 shares and pocket your full investment of $10,000.
However, let’s assume you’re wrong. Let’s assume Company A does well, and Stock A goes up to $200 per share. If you had to return the 100 shares of Stock A here, you’d have to spend $20,000 — $10,000 from your original sale of Stock A and $10,000 of your own money. So, in the end, you’d lose $10,000.
But now, let’s say you didn’t have to return Stock A when it hit $200. Let’s say you were still convinced Stock A would plummet in value. Well, if Stock A’s value continued to rise, your losses would only grow. At $250 per share, you’d lose $15,000. At $300, you’d lose $20,000. At $400, $30,000. And so on.
It’s this unlimited loss potential that makes short selling so risky. If you guess right, you can make a nice little profit for yourself. But guess wrong, and your losses will depend on your ability to tap out.
2. You don’t how the market will behave
No matter how informed you are, your short-selling strategy is essentially a guessing game. Even the most well-informed short stock investors won’t guess the market right, not to mention do it enough to turn a significant profit.
Take GameStop (NYSE:GME), for instance. Before February 2021, many short-sellers had their eyes on this dying video game retail store. For nearly a decade, GameStop struggled to keep up in a world that preferred digital over physical video games, and stock had been falling. Though a crew of new executives brought stock prices up in January, short-sellers expected GameStop shares to fall again.
And they might have, if not for Reddit group WallStreetBets. Members of the group noticed investors were short selling GameStop stock. In a move that baffled nearly every investor, these investors performed a short squeeze — they bought stock and drove the price of GameStop stock up. As a result, short-sellers began to lose a large amount of money at an increasing pace.
The GameStop case may seem like an anomaly. But it illustrates a major risk of short selling: you truly don’t know how the market will behave. Just when you think a company is smoldering in its ashes, a group of investors rekindles the fire. And if you’re on the losing side, your losses put you in a big hole.
3. You’re borrowing someone else’s stock
Finally, the shares you borrow aren’t yours, and you have an obligation to return them. If the shareholder who lent you the stocks wants them back, you have to give them back. Period. This could lead you to close your position before you can turn a profit, which means you’ll have to swallow your losses and repurchase their stocks.
When does shorting a TSX stock make sense?
More often than not, those who are successful at shorting a stock have well-informed reasons for selling high and buying low. For example, they may see a fundamental flaw in the business that will erode its value or hurt its market price, or they could see a bigger industry trend that will likely hurt a particular stock’s value.
Note: successful short stock investors typically don’t act on a “hunch.” They’re experienced, and they have good reasons to believe the price investors are willing to pay today is much higher than what they’ll be willing to pay in the future.
Is short selling illegal?
No. But in Canada, short selling may see some regulation in the future. That’s because some investors are engaging in certain questionable practices, most notably “short-and-distort” campaigns. In these campaigns, short-sellers will sell borrowed shares of stock, then use social media or other means to publicly attack companies, thereby bringing the stock prices down. When the prices are low enough, they repurchase the shares and profit from the price difference.
Conversely, some short-sellers will use a “pump-and-dump” strategy, which spreads positive (but false) rumours about a company, raising stock prices momentarily. This gives short-sellers enough time to sell borrowed stock before the prices go back down.
The Canada Securities Administration (CSA) is well aware of these problems, and they’re working on making new short-selling regulations.
Check back on this page for more information as regulations are put in place.
Should you short a TSX stock?
Shorting a stock can be a profitable investing strategy if you’ve identified stocks that will drop in value.
But that’s the trick — you have to be sure a stock’s value will actually decrease. If it doesn’t, your loss has unlimited potential, which could put you out of a lot of money.
For this reason, you should only short a stock if you’re an experienced investor. Even then, don’t rely on stock shorting alone for your market gains. The best strategy (beginner or expert alike) is to invest in great stocks for the long term. If you want to short a stock, do so with caution, but don’t sacrifice any long-term growth for short-term gains.