The Saga of GameStop and Short Selling

It is rare when a single stock’s trading movement gains widespread attention across the public and the media. It is a testament to our 24/7 news cycle and the prevalence of social media. It is also a reflection how unusual this situation is. If somehow you missed the news, the stock of GameStop (GME) has skyrocketed in the last two weeks. This is due to buyers of the stock creating a “short squeeze”.

To understand a short squeeze, you have to understand what it means to “short a stock”. Shorting a stock, in its most fundamental iteration, is the act of selling shares you do not own. An investor shorts a stock when they believe it will decline in price. Once the stock declines to the investor’s target price, they buy the stock back in effect closing out the short.

For example:
Investor A decides Tesla (TSLA) is overpriced at ~$820 per share. They put in a sell short order for 100 shares for $82,000. If Tesla goes down to $775, the investor buys the stock back for $77,500. The investor pockets the difference, $82,000-$77,500=$4,500.

The above is a simplified example to give you a sense of what occurs when creating and closing out a short. Personally, I have only engaged in short selling on a handful of occasions. I do not recommend it. If you buy a stock, the risk is that it could go to zero. You have risked the cost of the purchase. With a short sell, your risk is infinite.

The GameStop situation is a bit more complex. Hedge funds have targeted the company by short selling. They believe the bricks and mortar business model was no longer viable. For much of 2020, the stock languished under $5. Then things got interesting. An online forum of retail investors/day traders began touting the stock as a buy.

As these investors poured into the stock, it began to create the short squeeze. In order to limit losses, the hedge funds have to buy the stock back to close their position. The buy backs along with the day traders have propelled the stock far beyond its intrinsic value. Of the 13 million investors using the Robinhood trading app, nearly 50% have purchased the stock.

To further complicte matters, at this stage, new short sellers are creating new short positions. Hedge funds have been forced to liquidate long positions to offset losses. This is contributing to market volatility.

Unfortunately, this will not end well. People, mainly the small retail investors will suffer losses. Instead of creating well diversified portolios, they are gambling on stocks. This is a bubble caused by speculation. Like the tulip mania of the 17th century, the bubble will pop and people who can ill-afford it will lose.

Don’t get caught up in the mania. Have a plan, set your goals, understand your risk profile, and invest for the long term.
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