Short sales can make or break you

Q. Our company stock took a dive, and I and a lot of my co-workers lost more than half our life savings in just a few days. The only explanation we've been given is that a hedge fund sold us short. How could that impact the price of a stock so severely? Is there a chance the stock could recover just as quickly? Shorting a stock is very speculative, and therefore you can either make a lot of money or lose a lot of money with this strategy. When a person shorts a stock, they are betting that the stock is overvalued and that the price will soon drop. The stock is borrowed from another investor or a brokerage firm and then sold to another buyer. The proceeds from the sale go into the "shorter's" account. So, the shorter has sold stock they don't own and eventually they have to deliver the borrowed shares back to the lender. If the stock price declines, they buy the stock to cover the short and make a nice profit. If the stock price rises, the investor can have significant losses.

Simplified example: I borrow 100 shares of XYZ at $10 a share, and my brokerage account is credited with $1,000. The stock falls to $5 a share, and I buy 100 shares for $500 and return the 100 shares to the lender. I've made a profit of $500 ($1,000 minus $500). If the stock price rises to $15 a share and I either want or am required to cover my short sale, I will need to spend $1,500 to buy the 100 shares, and I've lost $500. When you short a stock, at some point shares borrowed must be paid back, which means buying the shares at the same price (no profit or loss), a lower price (generating a profit) or a higher price (generating a loss).

A short squeeze occurs when the shares of a shorted stock are bought aggressively, resulting in a rapid increase in the share price. As the price increases, people shorting the stock begin to panic and buy the stock to cover their borrowed shares, which in turn drives up the price of the stock.

Some critics blame short sellers when a stock price declines. They are said to have undermined the basic value of the stock by the mere shorting of the stock. Other evidence suggests that the short sellers are merely the bearers of bad news. They target companies that are overvalued and have valid reasons to expect the stock price to decline, such as management problems, lower than expected earnings, adverse media attention, etc.

Sometimes directors and officers go on margin with company stock, meaning they borrow money to purchase shares. When the share price falls, they experience a margin call requiring them to come up with additional cash or sell shares to cover the margin call. This selling can cause the stock price to fall further, and short sellers reap the profits of the stock's price decline.

One thing is certain, never own too much of one stock in your investment portfolio.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question.