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What is short selling and why is it such a controversial move?

The world of investing can be really complex. Therefore, we will explain what it means to short sell and why it is a criticized practice.

Clock next to some coins

We tell you what it means to invest short and why it is a movement with many criticisms. / Photo: Pixabay

LatinAmerican Post | Ariel Cipolla

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The Wall Street stock market has always been the subject of controversial movements. The most recent occurred hand in hand with the GameSpot case, which generated a scandal in the investment world. We are talking about small investors who shot up the price of companies that were going through difficult financial situations and that other "traders", more professionals, took advantage of to make a profit after the shares fell.

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Precisely, S3 Partners (a company specialized in analyzing stock market movements) estimates that investors who were inclined towards this type of operations have lost more than 4,100 million euros (5,000 million dollars) due to users of the social network Reddit. To understand this earthquake in the economy, you have to understand what shorts are and why short selling can be risky and frowned upon from a moral point of view. Let's learn more.

What does it mean to short sell 

When it comes to short selling, the first word that comes up is "controversial." About a year ago, we had seen that the National Securities Market Commission had decided to prohibit short positions in 69 companies listed in Spain. This is so because there is speculation, precisely, with the possibility of bankruptcy.

The problem occurs in other places, such as Wall Street, where there are no regulations preventing these situations from occurring. To better understand this financial situation, you have to understand the ways there are to earn money. The easiest is upside action, which happens when a stock rises. That is, you buy them at a low price, wait for it to rise, and then sell them.

It is the most basic form, since everyone understands the mechanism and it is the one that most investors use at first. In other words, it is speculated that a company can improve and that you can make a profit for that. However, there is also a riskier way that implies the opposite: waiting for a company to do poorly.

When a person invests waiting for the stock to fall, they are said to be taking a short position. On the contrary, when you buy stocks waiting for it to rise, you are long. The former are frowned upon, the latter not. Therefore, when someone buys massive stocks in the long run they do not need to declare them (except in important percentages), while, in the short, they need to declare them quickly.

So, we are talking about betting on failure. GameStop is the most obvious example, where Bloomberg reports that it had a year of losses in excess of 275 million dollars that are justified, in part, because it is based on a physical game store in a world that seems to choose the path towards digital.

Precisely, the negative trend of the company caused some investors to borrow shares. In other words, the short investor must pay someone to have them for a while. When a certain point is reached, where the stock is supposed to fall, he buys them back much cheaper and returns them to their owner. The gain arises from the difference of the sale and purchase price, less the value of the loan.

The problem occurs as it did in this case: when unforeseen events occur that cause the company to start to increase the value of its shares. This is what happens with the strangulation (short queeze), where short investors cannot buy back the shares and return them to their rightful owners, as they have increased in value and losses can be limited.

If a person spends $ 10 on a share, the most he can lose is that $ 10. On the other hand, if someone decides to short a $ 10 stock and the company goes public, there are no limits to losses, as the stock can go up incredibly and the investor will have to pay the new value to his lender. In other words, it is a risky situation, because you need to be able to return the money to the new value.

So if we take into account the GameStop case, in March 2020 the all-time low was about 3.50. Short investors were waiting for the price to drop even further, but Reddit users agreed to invest massively in the company and this caused the stock to skyrocket to peaks of more than $ 400, which implies millionaire losses for those who have to return the shares.

Not only is it a risky investment strategy from the economic point of view, but morally it played with the possibility of companies going bankrupt. Ultimately, you will be hoping to win if other people do badly. Therefore, the most logical thing would be a win-win relationship, where the company has benefits and you too, without the need to reach unlimited losses.