[gasps] Philip, come here.

Look.

What?

A huge tree fell on our neighbor's car last night in the storm.

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!

Um, 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 yowls] meowrrr!

♪ Whenever you purchase an investment, you're hoping that it will go up in value.

By buying a company's 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 in 1609 when a Dutch businessman named Isaac Le Maire speculated that the Dutch East India Company's stock was due for a big drop, [toilet flushes] 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 blamed 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.

[band plays fanfare] ♪ 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 ten 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 ten 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 ten 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 a 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?

[cash register rings] This is bad news because, remember, he doesn't owe the brokerage $2,000.

He owes them ten 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 ten 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.

One hundred percent 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?

[gasps] Or how leaky seawater is going to ruin the taste of pepper?

[groans] bleh!

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, well, a sizeable 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.