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I recently read this article about a day trader that lost $100,000:

A trader started a GoFundMe page to pay back $100,000 to E-Trade after a disastrous short

Please explain this, because I can not understand how this "trader" lost so much money. He says he sold 8400 shares at 2 dollars... that's $16,800 USD; how could he be in debt to E-Trade for $100,000 USD?

Did he buy this 8400 shares with just his money, or in margin account (50%/50%) from the Etrade money?

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    I don't see a 'scandal' here? I see an options trader selling a naked short, which is a bad idea for the reasons made clear in that story, and then begging people to help him out (hint: they won't). Read up on options trading if you don't understand it. – Joe Nov 20 '15 at 16:26
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    He SOLD 8,400 shares that he had to buy back at 9 times the price. – JB King Nov 20 '15 at 16:35
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    When you buy a stock your loss is limited to the purchase price and your gain is unlimited. When you short a stock your gain is limited to the selling price and your loss is unlimited – Ross Millikan Nov 20 '15 at 20:13
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    He lost so because he didn't have a written plan, he didn't employ money management, and he didn't have a risk management strategy. – Victor Nov 20 '15 at 20:34
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    @Joe according to Business Insider the idiot had found people willing to throw $1500 at him at one point. However it appears that Go Fund Me pulled the plug on him, since the link to it from BI is dead. I hope someone convinces him to consult with a bankruptcy attorney before he liquidates his/his wife's retirement funds; otherwise "live by the sword, die by the sword" seems to sum it up perfectly. – Dan Neely Nov 20 '15 at 21:09
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The day trader in the article was engaging in short selling. Short selling is a technique used to profit when a stock goes down. The investor borrows shares of a stock from someone else and sells them. After the stock price goes down, the investor buys the shares back and returns them, pocketing the difference.

As the day trader in the article found out, it is a dangerous practice, because there is no limit to the amount of money you can lose.

The stock was trading at $2, and the day trader thought the stock was going to go down to $1. He borrowed and sold 8,400 shares at $2. He hoped to buy them back at $1 and earn $8,400 profit. Instead, the stock went up a lot, and he was forced to buy back the shares at $18.50 per share, or about $155,400. He had had $37,000 with E-Trade, which they took, and he is now over $100,000 in debt.

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    Comments are not for extended discussion; this conversation has been moved to chat. – JohnFx Nov 21 '15 at 0:03
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    In order to authorize these trades, does E-Trade not have to have protections in place? Or can they not because they can't predict how high the stock goes... I don't understand how the user is on the hook for E-Trade instead of on the hook for whoever he bought/sold the shares from. I understand how he lost so much, but not why he owes E-Trade... – corsiKa Nov 21 '15 at 3:27
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    Why didn't he use a stop loss? – Niklas Rosencrantz Jun 16 '16 at 15:42
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    @DacSaunders: If someone has a pending limit order to sell up to 100 shares at $3/share, someone else has an order at $30/share, and nobody else has any interest in selling below $30, then until someone tries to buy 101 shares the price will be $3. As soon as someone tries to buy a 101st share, the price will jump instantly to $30. By the time the price goes above $3, all of the shares that could have been had for less than $30 each will have already been sold. Anyone who needs stock but didn't buy it for $3 will have to pay $30. – supercat Nov 22 '16 at 23:17
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    @corsiKa One of the main purposes of brokers and exchanges is to avoid the annoyance of random buyers and sellers winding up on the hook to each other and having to sue random people to get the money they're entitled to. Instead, the seller's broker deals with the buyer's broker or the lender's broker deals with the borrower's broker. – David Schwartz Jan 17 '17 at 9:52
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Learn something new every day... I found this interesting and thought I'd throw my 2c in. Good description (I hope) from Short Selling: What is Short Selling

First, let's describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company.

You buy/sell stock to gain/sell ownership of a company.

When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.

Still with us? Here's the skinny: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

So what happened?

The Plan

  • The company blows. It's shutting down. Only idiots will buy the stock.
  • Sell stock at $2/per
  • Buy it back at $1/per
  • Pocket the $8,600

The Reality

  • Martin Shkreli buys a 50% stake making everyone else buy the stock as well.
  • Sell stock for $2/per
  • Buy it back for $18.50/per
  • Immediately lose $37k sitting in bank
  • Owe $104k to Etrade - the company/person you borrowed the stocks from.

Lesson

I never understood what "Shorting a stock" meant until today. Seems a bit risky for my blood, but I would assume this is an extreme example of what can go wrong. This guy literally chose the wrong time to short a stock that was, in all visible aspects, on the decline.

How often does a Large Company or Individual buy stock on the decline... and send that stock soaring? How often does a stock go up 100% in 24 hours? 600%?

Another example is recently when Oprah bought 10% of Weight Watchers and caused the stock to soar %105 in 24 hours. You would have rued the day you shorted that stock - on that particular day - if you believed enough to "gamble" on it going down in price.

  • Yes a good example of when someone takes a gamble on the direction of the stock, they could have gambled on going long or going short, the only difference the losses on going short are potentially unlimited. By gamble, I mean this person put down a large trade (relative to his account size) without having a written plan, without employing money management, and without any risk management strategy. – Victor Nov 20 '15 at 20:43
  • @Victor Well, I think the real issue is the percentages... When you buy a stock that's THAT cheap, the odds of it doubling (or more) are going to be much higher than say... Apple stock which is currently $~119. What are the odds of going from $2/per to $/per? The odds of going $119/per to $240/per? A $2 increase for the first stock is 100%. An increase of $2 for Apple is a 2% increase... MUCH larger effect for the first. – WernerCD Nov 21 '15 at 15:48
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    Whatever happens after you buy Apple, the worst that can happen is that you lose all your money. If you sell short, you can lose a lot more than all your money. – gnasher729 Nov 21 '15 at 21:23
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    @Victor Right. It's the market cap that makes it so much more likely to be volatile, not the share price. The odds of some small-cap stock soaring 600% overnight are much higher than those of some giant hundred-billion-dollar company's stock doing so. On the other side of it, the odds of a small-cap stock going to 0 overnight are also much higher than the odds of a large-cap stock doing so. – reirab Nov 23 '15 at 1:34
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    To add insult to injury, the company in question, KBIO, has since declared bankruptcy and its stock was selling for $1.10 a few days ago. It's now a bit over $3. One needs a big bankroll to short a stock like KBIO that can't be hedged. Someone shorting Weight Watchers, at least, could hedge by buying calls. – Mark Plotnick Jan 17 '16 at 1:11
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He didn't sell in the "normal" way that most people think of when they hear the term "sell." He engaged in a (perfectly legitimate) technique known as short selling, in which he borrows shares from his broker and sells them immediately. He's betting that the price of the stock will drop so he can buy them back at a lower price to return the borrowed shares back to his broker. He gets to pocket the difference.

He had about $37,000 of cash in his account. Since he borrowed ~8400 shares and sold them immediately at $2/share, he got $16,800 in cash and owed his broker 8400 shares. So, his net purchasing power at the time of the short sale was $37,000 + $16,800 - 4800 shares * $2/share. As the price of the stock changes, his purchasing power will change according to this equation.

He's allowed to continue to borrow these 8400 shares as long as his purchasing power remains above 0. That is, the broker requires him to have enough cash on hand to buy back all of his borrowed shares at any given moment. If his purchasing power ever goes negative, he'll be subject to a margin call: the broker will make him either deposit cash into his account or close his positions (sell long positions or buy back short positions) until it's positive again.

The stock jumped up to $13.85 the next morning before the market opened (during "before-hours" trading). His purchasing power at that time was $37,000 + $16,800 - 8400 shares * $13.85/share = -$62,540. Since his purchasing power was negative, he was subject to a margin call. By the time he got out, he had to pay $17.50/share to buy back the 8400 shares that he borrowed, making his purchasing power -$101,600. This $101,600 was money that he borrowed from his broker to buy back the shares to fulfill his margin call.

His huge loss was from borrowing shares from his broker. Note that his maximum potential loss is unlimited, since there is no limit to how much a stock can grow. Evidently, he failed to grasp the most important concept of short selling, which is that he's borrowing stock from his broker and he's obligated to give that stock back whenever his broker wants, no matter what it costs him to fulfill that obligation.

  • Many financial operations are arguably legitimate. With shorting and high frequency trading considered even less legitimate than other financial operations by those who oppose their legitimacy. – Jose Antonio Dura Olmos Nov 22 '15 at 15:49
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    Shorting is legal; it just isn't wise unless you are absolutely certain you can tolerate the worst-case loss. There are ways to use it to hedge a position which are absolutely legitimate. Like a chainsaw, it's a fine tool when used properly by someone who knows what they'rd doing and is wearing safety equipment; dangerous but able to do things a less dangerous tool can't, and the danger can be limited. In the hands of someone with no training or who ignores the hazards, it can take off a leg or worse before they know what happenned. – keshlam Nov 22 '15 at 23:20
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    @DmitryGrigoryev ignorance. Or feigned ignorance in an attempt to garner sympathy. I find it somewhat incredulous that someone who would risk their entire brokerage account would be unaware of this since the phrase "potentially unlimited losses" comes up a lot when talking about shorting (as shown by the answers in this thread). – Jared Smith Nov 23 '15 at 17:19
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    @keshlam there is no worst case. That's the whole problem with shorting. In the USA for instance the SEC already requires individuals to pass certain income/net worth thresholds to engage in certain types of high-risk investing (like venture capital investments), I fail to see how a similar argument could not be applied to shorting. – Jared Smith Nov 23 '15 at 17:22
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    And brokers will discuss this with you directly before they will authorize your account to take short positions. And their web sites, mobile apps, and paper forms say that losses can exceed amounts invested and on deposit all over them. This is one of the reasons many people who take these kinds of risks use a vehicle like an LLC rather than a personal brokerage account. – David Schwartz Jan 17 '17 at 9:56

protected by Ganesh Sittampalam Aug 27 '16 at 10:02

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