You saw Gamestop’s stock price going to the moon, you heard about the naked shorts with AMC, but you’re wondering what are these terms and what do they mean? In this mini-guide, we tried to be as brief as possible so you understand the basics regarding short-selling.
What’s short selling?
Usually, most retail traders are looking for a profit by buying low and selling high, which sounds logical. But what if there was a way of making money with the opposite scenario? A short trade is done when a trader borrows a share, sells it to someone else, and when that share’s price goes down, he or she buys back that share. This practice is often conducted with the help of automated trading software. The difference between both prices, minus the commission and interests, becomes profit.
For example, Mr. Dupont borrows 10 shares at $10 each. Sells them all at $10 for a total of $100, making him ‘short’ of 10 shares. A few days later, the stock price goes down to $5. Mr. Dupont decides to go on the public exchange and buy 10 shares at 5$ each. Therefore, he can give back the borrowed shares, with a profit of $50.
If we put this scenario into numbers: (10 x 10) – (5 x 10) = $50. Well done, now you know the basics of short selling!
You will often hear the term ‘having a hedge’ while trying to understand what investing in stocks is all about. Hedging in trading is almost like having an insurance policy. Let’s say you own a house in a zone that is prone to forest fires. You can’t really prevent the forest fires, but you can however buy insurance to cover your house in case there is a fire.
So how does hedging works in the investment world? Commonly speaking, an investor will sometimes invest in options, swaps, or contracts, etc., that are going against his/her initial investment. These are respectively called derivatives and underlying assets. If the latter is a loss, the derivative will mitigate or offset the losing investment, which could be a stock, currency, or indices investment, for example.
What’s a short squeeze?
Lately, this term became very popular among the meme stock stories, along with the ‘naked shorts’. Basically, a short squeeze happens when many traders who were short selling are buying back their position. So on top of attracting many new buyers, which makes the price go up even higher, shorts are also being processed, sometimes launching the stock’s value to the moon.
Please note that naked shorting is an illegal practice, and revolves around short selling shares that do not exist publicly, yet. So now if you hear about a short squeeze coming up, or an investor having a hedge, you will know what it means.