Love it or hate it, the great GameStop kerfuffle of 2021 has done an important public service: It’s brought the investing technique known as short selling into the mainstream, and beautifully illustrates why it’s such a horrible idea.
Using GameStop as an example, let’s find out more about this controversial “investing” method.
What’s the GameStop saga all about?
Even if you’ve been keeping up with the news, the GameStop saga is not easy to understand, being a battle of one type of nerd (Reddit trolls) against another (Wall Street finance bros).
It all started when Melvin Capital, a hedge fund, published an article about how people should short-sell stock from a brick-and-mortar video game shop called GameStop.
When you short sell, you essentially bet that a stock’s price will decline. If the stock price rises instead, you lose money.
The second player in this sordid tale is a bunch of users on r/WallStreetBets, a sub-Reddit dedicated to stock and option trading mainly populated by speculators. Some of these users are seriously cashed up and spend their days on the internet debating wild trading strategies.
As internet trolls are wont to do, the Redditors decided to shake things up by suddenly raising the stock price to screw over Melvin Capital.
To raise the stock price, the r/WallStreetBets Redditors did a “short squeeze” by buying up the stocks en masse. This caused the GameStop stock price to jump from $20+ to $200+, bringing Melvin Capital’s potential losses to billions and dragging them to the point of bankruptcy.
Another hedge fund, Point72, decided to help Melvin Capital with a $3 billion capital injection.r/WallStreetBets reacted by pushing the share price up even further, and Melvin Capital lost everything.
By then, GameStop had made the news and regular investors started jumping into the fray, and the whole affair escalating into a confused melee. GameSpot became the most traded equity in the world on 26 January.
Since then, GameStop share prices have plummeted as brokerages move to curb trading of their stocks — causing an outcry from investors.
Never thought finance could be so exciting, eh?
What exactly does “shorting a stock” mean?
Melvin Capital’s downfall was brought about by their attempt to “short” GameStop stocks.
Very simply put, shorting a stock is basically betting on the decline of the stock’s price. You win the bet (and make a pile of cash) when the share price does indeed fall.
But of course, there are no guarantees in investing. So if the share price goes UP instead, you stand to lose money — in some cases, an unlimited amount of money.
Although professional hedge fund managers sometimes short sell in order to hedge against other risks, short selling is considered a speculative form of trading.
We don’t recommend short selling as a technique for regular investors like you and me. Heck, even the pros are fallible.
But why is short selling so risky?
Of course, there may be legitimate reasons to short a stock. Had you known that COVID-19 would happen, for example, you could have made a killing by shorting aviation and travel stocks.
Does that mean you should short sell Company X because you have intel about how they’re going down the drain?
Well, no. There are a few reasons why it’s super risky to short a stock:
- Short selling always involves a loan (“margin trading”)
- Your potential losses are practically unlimited
- No matter how sound your research, “short squeezes” can happen
These 3 factors, taken together, mean that short selling is a particularly high-risk form of investing.
1. Short selling always involves a loan
Here’s how short selling works, in simple terms:
First, you borrow shares from the brokerage based on your belief that their value will decrease by an expiration date designated in the future.
Before that expiration date arrives, you sell the (borrowed) shares at the market price.
Since you need to return the borrowed shares later on, you have buy them back to return them. If all goes well, they’ll be trading at a lower price, so you profit. Otherwise… you know how the ending goes.
So, your profit = (the money you made from selling the borrowed shares) minus (cost of buying back the shares).
As short selling requires you to borrow stocks, you will essentially be margin trading, which means trading on funds borrowed from the investment brokerage.
Brokers typically require you to have a percentage in cash and then lend you the rest. As with most forms of borrowing, they typically charge interest, late fees, and so on.
2. Your potential losses are practically unlimited
When you invest the regular, vanilla way, your losses are limited to how much you put in the stock market.
For example, Boring Benny invests $10 in a dud company, and its share price goes to $0. Okay, so Benny lost $10 — that sucks, but at least that’s the end of the story.
But with short selling, your risk of loss is basically unlimited. The higher the stock price climbs, the more you lose.
Let’s say Benny’s friend, Arrogant Aaron, tries to short a stock at $10. It backfires, and the stock climbs to $100. Now Aaron has lost $90 per stock, because he had to sell the stock at $10 and buy back at $100. $100 – $10 = $90. Aaron loses 9X as much as Benny.
But there’s no upper limit to how high a stock can climb, so if Aaron’s shorted stock climbs to $1,000, he loses $990 per stock. That’s 99X as much as Benny.
Short selling is definitely not something inexperienced traders want to try at home because of how risky it is.
The fact you’ll be trading on margin makes it even riskier, as it means you can execute much larger trades than your cash reserves would ordinarily let you.
3. “Short squeezes” can and do happen
The GameStop brouhaha is a cautionary tale of how the best-laid plans can be ruined by random people on the internet.
It didn’t matter how sound Melvin Capital’s research about GameStop was. All that counted for nothing when an invisible army of Reddit users decided to execute a short squeeze — buying up large volumes of the stock in order to push prices upwards.
In GameStop’s case, the short squeeze was the result of a deliberate, coordinated effort by a bunch of Reddit users to manipulate share prices. Some are motivated by nothing more than a desire to stick it to the man.
In reality — outside of r/WallStreetBets — short squeezes aren’t that common an occurrence. After all, it takes some serious cash and/or coordination to be able to buy large enough volumes to manipulate the share prices so suddenly.
That said, it doesn’t always take a coordinated effort to cause a sudden rise in share prices.
Ultimately, stock market prices are determined by demand and supply, and external factors can contribute to a sudden fall and then spike in demand. For instance, COVID-19 has resulted in huge amounts of volatility in the US as investors ride the roller coaster of pessimism and optimism.
Should you jump on the GameStop bandwagon?
By now, you should know not to touch short-selling with a ten foot pole unless you know what you’re doing and can afford to do it.
But what about jumping on the GameStop bandwagon and buying stocks in hopes of profiting from the volatility?
In theory, you can buy GameStop shares from Singapore so long as you are using an investment brokerage that lets you trade on the New York Stock Exchange (NYSE), where GameStop shares are traded.
But some brokers in Singapore have curbed purchases of GameStop stock, including Phillip Securities and UOB Kay Hian. So, if you want in, you will need to find a broker that still allows trading of GameStop stocks. Not that you should, of course!
As for the rest of us…
While GameStop is a headline-grabbing anomaly, this sordid affair reminds us that stock prices can ultimately be artificially manipulated by internet trolls, rogue traders and hedge fund managers.
And that’s on top of being dramatically affected by anything that violently stimulates or cuts demand (like a pandemic).
For risk averse or newbie investors, it’s a good idea to steer clear of stocks vulnerable to great volatility. Opt for long-term investments in passive, diversified instruments like ETFs instead.
These will seldom make headlines or even be worth talking about, but they reflect how entire economies and stock markets as a whole keep chugging along, GameStop or not.
Finally, unless you’re an experienced or professional trader with wads of cash, it’s wise to stay away from all forms of margin trading, including short selling.
Found this article useful? Share it with anyone who’s confused about short selling.