What is Short Selling?
To understand why direct registration is so profoundly important to long term investors, you’ve first got to understand short selling. When most people invest in the stock market, they invest in companies they believe will do well. You ideally buy low and sell high for a profit. The worst case scenario is the company you invested in goes bankrupt and you lose all the money you invested.
Some much more experienced investors, especially hedge funds and investment bankers, make money by speculating on companies they believe are going to fail. Think of Toys'R'Us or Sears.
What happens while short selling a company:
Image: National Public Radio
Borrow shares from broker who is willing to lend them for a fee.
Sell those shares on the open market.
Buy back the shares after the stock goes down in price (or in the short seller’s dream scenario, the shorted company becomes bankrupt and price goes $0).
Deliver the shares back to the lender and keep the price difference.
“Naked” short selling skips the 1st step in this process and sells a share without first borrowing it. So, if you short sold 1,000 shares of Sears (SHLD ticker) at $4 per share and decide to buy to close at $1, you would have made a tidy profit of $3,000!
However, short selling has its downsides like any investment strategy. While the price of something can go no lower than 0, there is no limit to how high a price can go. This means short selling carries with it, infinite risk.
What is a Short Squeeze?
Now, suppose Sears had completely turned things around in a big positive way after you short sold those 1,000 shares at $4. Instead of falling to $1, Sears actually climbed to $41. You then would have lost $37,000 (sell first at $4, buy-to-close at $41). Now, to illustrate a point, let’s exaggerate that scenario. Say you had your life savings of $50,000 in that account. You short sold 12,500 shares at $4 per share because you were convinced that Sears was going bankrupt in time. Then, the price of Sears actually skyrockets overnight due to a major breaking news story. When you wake up, the price is at $20 and climbing fast. Well, at $20, you already lost your entire life savings. Plus, you owe your broker another $250,000 so far!
Let’s say that there were quite a few other people who thought Sears was headed for bankruptcy and bet short against it. Well, in a situation like this you’re all facing steep losses and the potential for them to keep mounting to infinity. As soon as one person starts buying to stem their losses, the price rises and the others who haven’t bought yet continue to lose even more money.
Short sellers trade on margin (loaned money, they don’t need to have all of the cash on hand), and if they lose enough money they’ll get margin called (forcibly liquidated and required to buy what they short sold to stop losing money and pay up to whoever was lending them money). It creates a positive feedback loop of shorts buying to save their skins and margin calls forcing shorts to buy with massive price increases as all the shorts rush for the exit - that is a short squeeze.