- Thank you to Ancestry for supporting PBS.
(gasps) Philip, come here, look.
- [Philip] What?
- A huge tree fell on our neighbor's car last night
in a storm.
- Oh, that's awful.
- It's amazing, we're going to Cabo, baby!
- What are you talking about?
- Well, I had a hunch
that something horrible was gonna happen to them,
so I went and bought
a massive insurance policy on their car.
Make it rain, baby!
- Is that legal?
- Oh, you're such a Boy Scout.
Now, if I can get something bad
to happen to their cat,
we can upgrade to first class.
(cat meows)
(light upbeat music)
(pen scrapes)
(coins tinkling)
(coins whoosh)
(air whooshes)
- Whenever you purchase an investment,
you're hoping that it will go up in value.
By buying a company stock, you win if they win.
We're all in this together, right?
Well, not always.
- Since the very beginning of stock investing,
people have found a way to profit
when companies struggle or fail.
The first instance was 1609,
when a Dutch businessman named Isaac Le Maire
speculated that the Dutch East India Company stock
was due for a big drop,
and he wanted to make some money if he was right.
In Amsterdam at the time,
there was already a system in place
to make money if prices of grain fell,
and that gave him an idea.
Le Maire headed to the bridge in town
where stocks were traded
by an elaborate hand-slapping system, no joke,
and found somebody to take his bet.
- The process of speculating on the future fall
of a company's stock is called short selling,
or shorting, for short.
To most people, the process can seem confusing and complex
and it can create downward pressure
on a company or asset,
potentially ensuring its doom.
It's for these reasons that society tends
to dislike and distrust short sellers.
In 1772, a short-selling scheme precipitated
a near total collapse of every bank in Scotland.
- Many Americans blame short sellers
for the Great Crash of 1929
that led to the Great Depression.
And as recently as this year,
the short selling of GameStop and AMC stock
created such a fervor
that it caught the attention of Treasury Secretary Yellen
as a possible threat to the stability of markets.
- But how does this even work?
How do you bet that a stock will fall?
Essentially, the way to do it
is to borrow the stock from a brokerage firm
and then immediately sell it to someone else.
This is where the term short came from.
You are selling something you don't have,
or are short of.
When the price of the stock falls, as you expect,
you buy it back at the lower cost
and return it to the brokerage firm,
keeping the difference as profit.
- Sounds simple enough,
but is this the kind of investment
that the average person should attempt?
- To really understand the promise
and perils of short selling,
I think we need to-
- [Both] Run the numbers.
(dynamic classic game show music)
- Jannik works in the floral industry,
and recently observed a frenzy for tulip bulbs.
It's gotten downright crazy lately
with people trading wedding bands
and even used cars for a single bulb.
But Jannik knows a bubble when he sees one,
so he hatches a plan to short sell the stock
of the biggest tulip company in the world,
Tulips International, which just hit an all-time high
of $200 per share.
- His first step is to choose a brokerage firm
and open a special type of account
known as a margin account.
This will allow him to borrow shares directly
from the brokerage company.
He wants to short sell 10 shares of Tulips International,
so he borrows them from the brokerage
at the current price of $200 per share.
In order to lend him these shares,
his brokerage wants him to put some skin in the game
and requires him to deposit 25% of the loan amount
in his margin account.
That $500 is his only personal capital contribution
at this point.
The firm loans Jannik $2,000 worth of TLI stock
at 1% margin interest,
and he instantly turns around
and sells all 10 shares to Mila.
He puts Mila's $2,000 into his margin account,
and now sits back to watch the tulip bubble burst.
- Let's just say that Jannik's spidey sense
is proven right.
Over the next 30 days, the stock drops and drops,
losing half of its value.
He buys the 10 stocks back from poor Mina
for just $100 a share,
and returns them to the brokerage firm,
pocketing the difference.
Taking out $1.66 in interest for the loan,
and $10 in trading fees,
Jannik posted a gain of $988.34.
That's 197% profit
on his original contribution of just $500.
Sounds like a good gamble.
But the real risk in short selling
isn't the upfront cost.
- What if Jannik turned out to be wrong?
What if the share price didn't fall
but continued its climb,
eventually reaching $300 per share?
This is bad news,
because remember, he doesn't owe the brokerage $2,000.
He owes them 10 shares of Tulips International,
and he'll have to get them back
no matter how much it costs him.
Maybe he thinks the price will still fall
and he can wait it out,
but the brokerage firm
won't allow his debt-to-deposit ratio to get too high,
so he'll have to keep depositing money
into his margin account
as the price of the stock gets higher.
At this point, Jannik admits he is no Nostradamus.
He decides to cut his losses,
buy back the 10 shares for $3,000,
and return them to the brokerage company.
- This saddles him with a realized loss of $1,000
on the sale alone.
And once you include the trading fees
and interest he had to pay,
he's looking at a 202% loss,
which is obviously more than his starting amount of $500.
- This is why short selling is big-time risky business.
Typically, when you invest,
you can only lose up to the value
of the amount you purchased.
100% loss is the worst-case scenario.
But with shorting,
you can lose more than your starting amount,
as poor Jannik found out.
In fact, since the gains on the investment
are technically unlimited,
short selling creates the possibility for infinite losses.
Yikes.
- Nevertheless, short selling is and always has been
a standard function of investment markets.
Everyday investors like you and me,
all the way to Wall Street hedge funds,
can short nearly any type of investment,
hoping that the price drops.
But sometimes investors aren't content to just hope.
They want to make it drop.
- Remember our friend Isaac Le Maire?
After he shorted the world's first stock in the 1600s,
he went around town
spreading rumors and lies about the company.
"Did you hear about the Dutch East India ship
that sank off the coast, (man gasps)
or how leaky seawater
is going to ruin the taste of pepper?"
(woman gags)
This would be considered unethical today.
But in a modern version,
when hedge funds team up and heavily short a company,
it can shake investor confidence.
The company goes into
an artificially accelerated death spiral,
with shorted investors gleefully hovering like vultures
ready to swoop in and claim victory.
- Well, at least that's how it usually works.
Sometimes the little guys decide to fight back.
Here to explain is CFA investment analyst Richard Coffin
from The Plain Bagel.
- In January of 2021,
a group of investors online discovered
that GameStop, a struggling video game retailer,
was being excessively short sold by hedge funds.
But while a sizable short interest
is usually a bad omen,
these investors used this information
to send the stock skyrocketing
by triggering what's known as a short squeeze.
A short squeeze occurs when a rising stock price
prompts a rush for the exit by short sellers.
Because these investors are losing money,
some may decide, or indeed be forced,
to cut their losses and buy back the stock
to close their position.
But by abandoning the short sale ship,
these investors end up sinking it faster
for those left behind.
Their buy orders can push the price higher still,
prompting other investors to jump ship
and buy the stock back themselves.
This positive feedback loop
can send a stock surging over a very short period of time.
And the larger the short interest to begin with,
the more returns can be squeezed out of the short sellers.
After buying GameStop shares
to get the ball rolling themselves,
our online investors prompted quite the surge in the stock,
with GameStop's share price jumping over 1,700%
in January alone.
Needless to say, it was quite the rude awakening
for those who thought GameStop's decline
was a sure bet.
- The long and the short of it is,
yes, you can make real money
when an investment falls in value.
But it's speculative,
and exposes you to the possibility
of unlimited losses.
- So before you dip your toe
into the world of short selling,
make sure you understand the risks,
are highly familiar with investing tools,
and aren't gambling with money
you can't afford to lose and then some.
- [Both] And that's our two cents.
- Thank you to Ancestry for supporting PBS.
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- The stock market doesn't have to feel
like a high stakes casino.
Check out our video "How Risky is the Stock Market?"
(light upbeat music)