What Does Short Selling a Stock Mean?
The short stock definition is selling a stock you do not yet own. This is a very simplistic explanation, as there is a lot more involved in the strategy of short trading. Sharing short requires borrowing a stock from an owner to sell at a higher price, in hopes that the lender will turn around and sell it to you at a lower price.
A Hypothetical Short Sale Example
Here is a very simplified example: If you put in an order to buy five shares of X stock at $10 each, and then put out an order to sell those five shares at $12 each, you may be able to earn about $10, or $2 per share. That is the motivation for investors to short sell, particularly if they see a stock that is quickly increasing in value to the mean.
The risk is that if the buy order has not closed before you sell, you will need to borrow stocks at the market price in that instant in order to close the sale at $12 each. That cost to you $10 per share as you ordered or it may cost you $15 per share. In our example, if the cost is $15, you will lose $15 on this short sale stock.
Short Sales with Biotech Stocks
Biotech stocks tend to be very volatile, and that has some traders thinking that they will revert to the mean after any nice run. But with the potential for positive catalysts — like successful clinical trial data — the danger of shorting a biotech hoping for it to revert to the mean is heightened. You could be looking at a pop-and-go situation, where the stock simply moves higher. And that means losing money on short sale trading.
A Real-Life Biotech Short Sale Example
Consider the case of Cara Therapeutics (CARA), a clinical-stage biotechnology company, where someone might have shorted the stock after a significant run in the wake of the U. S. Food and Drug Administration (FDA) granting the company a breakthrough-therapy designation for its lead drug candidate. Cara then reported that it would be continuing Phase III trials of I.V. CR845 in patients with post-operative pain. These positive catalysts sent the stock higher, without any reversion to the mean.
The Effects on Short Sales of Cara
There were signs that you might not have wanted to short Cara. Here are some key statistics:
When a stock has a short interest, or short float, above 20%, it’s usually an indication that shorts could get squeezed, in the event of a positive catalyst. A squeeze happens when prices rise and investors have to buy to cover short sells, driving prices up further. That said, if you were part of this 23.89% of floating shares that were short, you would have gotten squeezed after Cara Therapeutics had two positive catalysts.
As you and the other shorts were rushing out of the stock, it simply pushes the price higher.
Here’s a look at how the stock performed as the shorts were squeezed after these catalysts.
The Bottom Line on Shorting Biotechs
Biotech and pharmaceutical stocks get increasingly volatile around news events, and when the stock has a high short interest coupled with a low float, it could indicate that the shorts might get squeezed and the stock might jump significantly higher if the catalyst event turns out positive. That is why you should do your research before short trading biotechs.