By now you’ll have read all about the GameStop saga and how the little Reddit guys took on the Wall Street giants. It’s played out like David and Goliath and totally blindsided the money capital of America.
The GameStop saga revolves around the controversial practice of short selling. Shorting as it’s called is not illegal and is often used by market makers to provide liquidity in response to unanticipated demand. It’s also used to hedge the risk of an economic long position.
Where short selling is dodgy is when shorters use market manipulation to drive down a beleaguered company’s share price for their own multi-billion dollar gain. They call these activist shorts.
Short selling is also very risky as Melvin Capital, the notorious hedge fund company caught in the eye of the GameStop storm, has found out to the tune of $3.5 billion in losses.
In this in-depth guide you’ll learn:
- What is short selling?
- How the GameStop and short-selling saga played out
- How short-selling works
- Is short selling legal?
- Would we recommend short selling?
And lots more…
Let’s dive right in…
What is short selling?
Short selling is speculating – read taking a gamble – that the value of a company’s stock will go down.
So, you borrow the stock, sell it at the current stock price, wait for the price to plummet, buy it back at a considerably lower price, give the stock you borrowed back and pocket what you made on the trade.
It’s the complete opposite of the centuries-old way people trade shares on the stock exchange. You buy low and sell high and hopefully make a handsome profit. When you short sell a stock and the price goes up, you’ve got a problem.
Let’s look at short in the simplest example:
| Jack gambles on the fact that the price of BMWs will go down.
He borrows a BMW from Mary that is currently valued at R200 000. He sells the BMW to David at the current market price of R200 000. A few months later the value of BMWs has crashed and you can get a BMW now for R80 000. Jack still owes Mary a BMW that he borrowed. Jack buys a BMW for R80 000 and gives the car back to Mary. Jack pockets R120 000. |
But…
If Jack’s gamble backfires on him and the price of BMW skyrockets to R500 000, he’ll make a loss of R300 000.
But wait! It’s worse if Jack is a short seller.
He has to pay R500 000 to get back his BMW stock.
Then…
He has to pay Mary R200 000 to close out the position.
That’s a whopping loss of R700 000. And he doesn’t even end up with BMW stock in his garage!
How the GameStop and short-selling saga played out
Basically, our simple BMW example is how the GameStop saga played out and how the Wall Street shorts got burnt.
Someone in the hedge fund team at Melvin Capital decided it was a good idea to short sell GameStop stock. It was a no-brainer; the video game company operates out of old-fashioned brick-and-mortar stores but kids don’t go into shops anymore to buy games. They download them now.
GameStop was throwing everything at the problem but it was inevitable; the company was battling to survive in the Internet era and the value of its shares was going down at a fairly rapid rate.
Unbeknown to the big guns, an astute bunch of retail traders spotted the hedge fund people were short-selling GameStop and they plotted the biggest blindside Wall Street has seen in decades. An army of individual traders led by the likes of the Wallstreetbet community gathered the troops on Reddit and got everyone to throw their money into the pot to buy up GameStop stock.
The GameStop buying rush went viral. Instead of it casually taking a downhill walk, GameStop’s share price skyrocketed in a matter of days. As of 27 January, GameStop’s shares were up nearly 1 700%. All this drama for an innocuous video store chain that really was facing a bleak future.
Melvin Capital suffered heavy losses as a result of them shorting GameStop and had to call on Citadel and Point72 to bail them out to the tune of #3 billion. The hedge fund had bet $3.5 billion against GameStop using put options.
Exciting times but Wall Street and the financial regulators are not happy.
How short-selling works
Traders have the choice of taking a long position or a short position on a security asset.
A long position means you own the security. You hang onto the security for a longer period of time with the expectation that the stock value will increase in the future and you’ll make a profit.
When you ‘go long’ on a stock, you can never lose more than the capital you invested. There is no limit on your potential gain. Remember, if you’ve traded on margin, you still owe the initial investment amount to the broker.
A short position is where a trader or investor does not own the stock. In other words, you borrow the security yourself or on behalf of an investor if you’re a broker. The short position is closed out by returning the borrowed security to the lender.
On a short position, if the price drops, you can buy the stock at a lower price, offset what you borrowed and make a profit. If the price of the stock rises, you buy it back at the higher price and take the loss.
For example, if you short a stock to the value of $5 000 and the stock value suddenly skyrockets to $10 000; you have to buy the stock back at the high price and then pay another $5 000 to the lender to close out the position. You’re down $15 000 and you don’t own the security.
To minimize risk on short positions, you need to set a stop-limit order which automatically closes out the position before the loss is too great.
Is short selling legal?
Short selling is legal and most online retail brokers allow it. What is illegal is naked short selling which is shorting without first borrowing the shares. In other words, where someone trades shares that don’t actually exist.
Short selling is bad when activist shorts cause temporary downturns of share prices into full-blown panic selling. Often this is done by spreading misinformation or plain old lies about a company and hyping it as a failing stock. They call this ‘short and distort’ and its these ‘pump and dump’ outlaws that give stock trading a bad name.
Activist shorters research companies to find targets, spread the word on social media or in the press that the stock is in trouble and then sit back and wait for the poor company’s share prices to plummet. The regulatory authorities and Wall Street don’t like short-sellers, but to date, shorting is still legal.
Would we recommend short selling?
Short selling is risky and when done as activist shorts with market manipulation, it’s immoral and unscrupulous. It’s a nasty thing to do to a company that’s experiencing a temporary share price slump as panic selling can destroy its reputation and bottom line.
There’s a fine line between short selling responsibly and doing some serious damage and losing a fortune. While short selling is legal for the moment, it’s not popular. Shorting is a way to profit from falling stock prices but it also has the highest potential for huge losses.
If shorting is a trading strategy that appeals to you; remember that regardless of how poor a company’s prospects look, there is always the chance of a pricing bounce-back. Gambling on falling stock prices and taking margin to borrow stock to play the Wall Street roulette table is a very risky strategy.
Leave short selling to the experts if you are a beginner or intermediate trader. Investing in the stock markets comes with a high degree of risk anyway and the potential of financial losses. Why heap even more risk on yourself by gambling on making money short selling?