Lessons on short selling

For most people, this is a game that is better watched from the sidelines as a spectator.
Short selling Gamestop stock

As I write this (February 5, 2021), much of the recent news has been about the big hedge funds suffering big losses due to the little guys’ collective buying power. You can say that it is a little bit of a David vs. Goliath story, and everybody is rooting for David. By the time this comes out in March, it might be old news. But there are some interesting lessons here that are worth talking about. A short sale trade is not for the faint of heart and involves a fair degree of risk. I should also point out that nothing I say here is to suggest that you should buy, sell or hold any of the stocks I talk about here. This is simply for educational purposes.

For those who might not be familiar with a short sale, that is when someone sells a stock they don’t own, receive the funds, and then hopefully buy it back when the stock price is lower, so you keep the difference. You might ask, “How do I sell something I don’t own?” The answer is that you actually borrow the shares from someone else in your brokerage account (the brokerage firm handles this for you), and you sell the shares. Of course, you have to put up funds as collateral and owe interest on that until you close out the trade by buying the shares.

Let’s say, for example, that you thought a certain stock was way overpriced and would be going down. If the stock price was $20 a share and you sold it short, you would receive the $20. If you were correct and it went down, and maybe you could buy it back at $10 a share, you would profit by $10. The important point here is that you eventually have to buy the stock so you can give it back to where you borrowed it from.

But what if you were wrong? If you buy a stock at $20, the worst that can happen is that it goes to zero. But if you are short, you eventually have to buy the stock, and it could be higher rather than lower. Unlike going to zero if you own it, there is no limit to how high the stock could go. You eventually have to buy the stock, and you have unlimited risk. You might say that is when you lose your shorts. Sorry. I couldn’t resist that one.

So what happened with GameStop Corp, symbol GME? GameStop runs a chain of small-format retail stores that sell video games, consoles, and assorted merchandise or accessories. If you have kids who play those types of electronic games, you probably have been dragged there many times, and it’s a popular place to buy things like that. Or at least it used to be. Now you can buy the same stuff online from the comfort of your couch. GameStop is also known for its used game business. You can sell used games for cash or trade-in value. And therein lies the problem. GameStop’s core business is under attack on multiple fronts by any number of online retailers. At the same time, the used game business faces the risk of irrelevance in the age of downloadable games such as Fortnite. (Don’t ask me what that is. It’s what the kids tell me.) While plenty of gamers still like owning the physical media because it uses less on-board storage and gives them something to eventually resell later, the path of least resistance is simply to download the game and be done.

You can see where this is going. Some people think it is a dying business and getting worse. All of this was true before the COVID-19 pandemic. We then had months of sporadic lockdowns and social distancing requirements that hit brick and mortar retail hard. That one-two punch made GameStop a popular target for short-sellers and became known as one the most heavily shorted stocks out there.

While individuals can sell short, the major short-sellers are large hedge funds playing with billions of dollars. Many traders watch short sale volume to see what percentage of a company’s outstanding shares are “short.” You would assume that is a big negative for the stock. It would be natural to think that if the big boys are short, things are going south for that stock, and you should play along also. Remember, if you are short, you eventually must buy, and if a lot of people try to buy all at once, the stock can go up rapidly, and you will be forced into buying at a major loss. And that’s what happened here. Along came Reddit and WallStreetBets.

Without getting too technical and beyond my knowledge, Reddit is kind of like a giant online chat room or message board with many sub-groups within that talk about a variety of topics. One of those is WallStreetBets, where a large number of people are interested in the stock market and trading stocks. They can instantly talk with one another and trade ideas. I don’t know how many people are on that site, but I understand that it is over 8 million. That’s a lot of buying or selling power when acting together. Members of that group started suggesting that GameStock was too heavily shorted and that if they could buy enough to force the price up, it would put the hedge funds in a bind. And that is exactly what happened.

Of course, small investors have been at the mercy of the big guys since forever. What is different this time? For the first time, the little guys could act collectively and be a large trading force. When they started buying in large quantities, it forced the price up and put the hedge funds in a big loss position. When they had to buy shares to close out their short positions, it forced the price even higher. They lost billions of dollars as they were forced to buy at any price just to get out. I understand that one hedge fund alone lost $4 billion. GameStop went from about $20 a share to as high as $480 a share. It was like pouring gasoline on the fire. Of course, early buyers made a killing on the way up and kept a large portion of it if they sold. Unfortunately, this will probably not have a happy ending for those who were late to the party and bought at high prices before it crashed back down. We’ll see. While any stock can temporarily go crazy from speculation, eventually underlying fundamentals matter.

Is there a lesson to learn from this? Indeed. For most people, this is a game that is better watched from the sidelines as a spectator. Thanks for reading.

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About Nick Massey

Nick Massey is President of Massey Financial Services in Edmond, Oklahoma. Nick can be reached at www.nickmassey.com. Investment advice offered through Householder Group Estate and Retirement Specialists, a registered investment advisor.