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What is a short?
You may have heard the term ‘shorting a stock’ and I guess the first thing that crosses your mind is ‘what does that even mean’. How can you, so called ‘SHORT’ a stock. Well, shorting a stock is also known as short selling and occurs when a trader basically places a sale of a particular stock that he or she does not actually own.
Q: Wait, hold on, how can someone can sell a stock they do not own?
A: Essentially, what actually happens is they borrow the stock form the broker and then sell it.
Q: Right, but why would anyone want to do that?
A: In short, people who short stocks (short sellers) take part in these type of transactions because they believe a stock's price is going to go down and so if they borrow the stock and sell it today, then they will be able to buy it back at a lower price at some point in the future. If the stock price goes down, then profits are made through the difference in the price of the sale and the price that they buy it back at. Now look, traders tend to short stocks purely for speculation purposes whiles others, particularly in the professional world, use this strategy to hedge/protect their existing positions.
Q: What is a short squeeze
A: Remember shorting requires you to sell, and then buy back the shares at a future date. In the prescribed time, if the stocks price is going up then you have a losing position, the broker will ask you to ‘cover’ your position with cash. This is referred to as margin calls. When it is time to buy back the stock, you will be in big trouble if the share price risen by a lot. Now imagine if there are many traders who have taken a short position in the same stock. Unfortunately, there are only a limited amount of shares available and so all the short sellers who now need to buy back the shares, will be forced to pay a higher price for it even further. This causes an excess demand for the shares which have already risen and again causes a further rise in the price. It results in a crazy spiral effect and this is what we saw occur with the Tesla stock on 04/02/2020.
Can you think of any companies that have many short sellers?