Short is a Funny Word – Or is it Scary?
February is a short month, which means it is not long. If you are short in stature, then you are not tall. If you are a man, you might be wearing shorts as underwear (or perhaps briefs which are shorter shorts), so a short is a thing. If you have an electrical path that is compromised, you also have a short. That is often dangerous, causing an electrical fire. If you go to the store with $10 in cash, and the item you want to purchase is $10.01, you are short cash. If you buy something that is not what was promised when you try it, you might feel shortchanged. Finally, if you think a company’s stock price is too high, and that it is likely to drop significantly, then you can “short” the stock. That brings us to a company: GameStop (GME).
Short Selling is based on Borrowing Shares from another investor.
You can lose your shorts if you short a stock. Short selling is a bearish strategy used to speculate on a potential decline in the underlying security. If, for example, you see a stock that is trading at $100 per share, and you think it will drop to $50 per share, you can short the stock. Investopedia has a great explanation of how this works. “Short selling involves the sale of a security not owned by the seller but borrowed and then sold in the market, to be bought back later, with potential for large losses if the market moves up.”
In other words, I can borrow a thousand shares of GME at $3 per share and then sell them at that price. That gives me $3,000. But I still don’t own the shares. If the shares increase in value to $300 per share, I would have to pay $300,000 to buy 1,000 shares, so that I could return the borrowed shares to the owner. The math is simple. I would lose $297,000 in this type of trade. What I am hoping for is for the stock to drop to $0.01 per share. I would then buy the 1,000 shares for $10 to return to the lender. That nets me a profit of $2,990. Of course, if I had purchased 10,000 shares, or 50,000 shares, my profit dollars could be much higher.
Margin is an expensive loan for short selling.
To make matters even worse, short selling is also more expensive than you might think because of the margin requirements. “Margin trading uses borrowed money from the broker to finance buying an asset. Because of the risks involved, not all trading accounts are allowed to trade on margin. Your broker will require you have the funds in your account to cover your shorts. As the price of the asset shorted climbs, the broker will also increase the value of margin the trader holds.” (Source: Investopedia)
If you are not a sophisticated trader familiar with shorting and the complexities of executing these trades, then you should never short a stock. Never. Let me repeat: NEVER.
Another Strategy is Covered Calls
The “covered call” options strategy is far easier to do and has far less potential for any loss. There is a downside to trading covered calls. (Notice the weird humor in this: I want to be covered, and not exposed by losing my shorts!) If I own 100 shares of WMT, I can sell a contract to someone willing to buy the shares by a contract end date at a price per share that I can specify. The buyer of the covered call gives me money in exchange for the right to buy my shares on the contract date – if the shares reach the price I said I would sell them. Using this strategy, I get the price I wanted for my shares and the profit from selling the covered call option contract.
This type of contract does have a couple of downside risks. If the share price increases well above the contract price, I still have to sell my shares at the pre-arranged price. That feels like I “lost” money. However, if I have already determined what the shares are worth, I am getting what I thought was a good price for the shares.
The other risk is that the company could report bad news, or some major economic, political or sector news could cause the price of the shares to drop dramatically. Sadly, I cannot sell the shares before the contract date, as I have promised them to a potential buyer. Therefore, I would never do a covered call with any investment I thought was unworthy of being a long-term investment.
On Friday, January 29, 2021 I purchased one share of GME for $250 at about 1:30 PM CST. About 40 minutes later I sold the share for $310, netting a gross profit of $60. My net profit was $59.99 for this trade after the sale charge. That is a gain of 24% on one share of stock. You can see why this can be a tempting way to make money. However, day trading is extremely risky. That is why I only purchased one share of GME.
Albert Mohler Explains Shorts Too!
This morning I noticed that even Albert Mohler is talking about this. “What Exactly Is Going On with GameStop, Reddit, and Wall Street? And What Does a Biblical Worldview Teach Us about the Stock Market?” LINK TO MOHLER. He talks about worldview in his wise commentary. GME has gone up 1,700% and what is the underlying cause or worldview that has caused this? Listen to Dr. Mohler to learn more. It isn’t a story about David and Goliath. At least not the true meaning of David and Goliath.
COVERED CALL LINK: INVESTOPEDIA COVERED CALLS
SHORTS AND PUTS LINK: INVESTOPEDIA SHORTS AND PUTS