Short-selling is a side of Wall Street people probably weren't familiar with until the meme stock craze in 2021. However, it can have a significant impact on share prices. That's both good and bad -- short-sellers can expose potentially fraudulent businesses, but they can also tear down otherwise good stocks in the name of profit.
Investors can't control short-sellers or the stocks they go after. But you can control what you do about them and whether they impact your investing strategy. Here is what you need to know.
Short-sellers can do good
It's not always easy to keep emotion out of investing, especially when short-selling is involved. You buy shares of a stock if you believe it's going up, and you short a stock if you think it's going down. Naturally, short-sellers can feel like public enemy No. 1 if they go after companies you invest in.
But shorts have a valid purpose; healthy markets require opposing views to function correctly. Shorting can be risky because a stock can go down only until it's worthless. However, there's no mathematical cap on potential losses if a shorted stock keeps rising. Not all short-sellers are created equal, but professional short-selling firms often do a respectable amount of homework to justify their positions.
That can sometimes expose fraudulent companies. Unfortunately, not every business works in good faith. For example, a firm publicly filed a short report on hydrogen truck company Nikola, alleging the company lied about its technological achievements, including faking a video of its prototype working. The company's founder has since been convicted on charges, and new management has taken over.
But they're not always right
Short-sellers don't always serve a public good, however. Of course, a short-seller's goal is to make money, which happens when share prices fall. There are examples of times when short-sellers picked on an unproven but otherwise sound business that endured short-term volatility only to thrive over the long term.
Tesla and Shopify are both former short-seller targets. They were shorted so much that over 20% (40% in Tesla's case) of all the publicly available shares were shorted -- that's a lot! But Tesla's stock has risen more than 4,000% since mid-2013, and Shopify's stock has risen more than 400% since early 2018. Investors who were scared of their investments might have missed out on these returns.
It's crucial to know why a short-seller is targeting a company. Targeting a fraudulent company saves investors from bad actors on Wall Street, even if it's not fun finding out a company you own isn't acting honestly. But sometimes, shorts are looking at less-proven companies that aren't doing anything wrong; they're just less established and more prone to the boat rocking that short reports can cause.
How to protect your portfolio
You can't control what stocks short-sellers go after or whether their short reports have merit. The best thing you can do is remain emotionally neutral and protect yourself first. Make sure your portfolio is diversified so that if you do end up holding a shorted stock -- especially a company that's potentially acting dishonestly -- your overall losses are minimal.
If a short-seller report is questioning the business model of an honest company, do your research. Read the report and decide for yourself whether the allegations carry water. It could be that the alleged flaws in the business are overly stated or the seller is off-base. Remember, like all other investors, they're not always right.
Keep your cool, diversify your portfolio, and you can gracefully handle unexpected turbulence from a short report.