GameStop, a struggling American video games retailer, has seen its stock jump about 18-fold since the start of the month (at least, that’s the figure as of this writing). Has it started manufacturing Teslas? Has it discovered a cure for Covid? Is it about to be taken over by a larger rival?
Nope. It’s just been the subject of a war between short sellers and a band of private investors. And the private investors are winning.
What is short-selling and why is it so high risk?
First, let’s explain what shorting is very quickly. (If you prefer to watch a video explainer, we do it in two minutes over here). Short selling is not complicated. But it is counter-intuitive, which is why people sometimes struggle to wrap their heads round the idea.
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Short selling is a way to profit from share prices falling, rather than rising. Here’s how it works: let’s say you think that shares in Magical Unicorn Rainbows plc are heading for an imminent fall. You’d like to profit from that. You find a friend who owns 1,000 Unicorn shares. You borrow those 1,000 shares from your friend. You pay them a fee for this, which is why they’re happy to lend them to you.
Then you sell the Unicorn shares in the open market. Let’s say the share price is £10 a share. So you now have £10,000. But you owe your friend 1,000 Unicorn shares – you are literally “short” of 1,000 shares. And the longer the loan is outstanding, the higher the fee you have to pay them.
Luckily, you’re right. Turns out that Magical Unicorn Rainbow plc’s CEO is embezzling the company, it’s just an elaborate Ponzi scheme, and better yet, the news breaks a week after you first sold the stock. The share price collapses to £1 a share. You buy back the 1,000 shares – it costs you just £1,000. You hand the 1,000 shares back to your friend (with perhaps a wan, consolatory smile). And you pocket the £9,000 profit (less the fee you owe your friend). So that’s a stylised example of how short-selling works.
What happens, though, if instead of being a Ponzi scheme, you are totally wrong, and Unicorn plc announces a massive new contract that sends the share price rocketing higher to £20? In that case, you’re left looking at the market with a stone in your stomach as you realise that you still owe your pal 1,000 Unicorn shares, and that you now need to pay £20,000 to get them. So you’re already down £10,000 on paper. You could wait. You could hope that the share price drops back a bit. But what if it just keeps going up? Will you crystallise the loss at £15,000? £20,000? What if it turns into a ten-bagger, and your losses end up in the six figures? At what point will you lose the house?
There’s another problem here. If lots of people had believed the same thing as you – that Unicorn plc was dodgy, and that they should short it – then there are suddenly lots of people in your position. The problem is, to close your short position, you need to buy stock. If you buy stock, that pushes the price up more. So as more and more shorts are forced to close their positions, the price goes higher, inflicting even more pain on the remaining shorts. Thus the name “short squeeze”.
You start to see how short-selling can go badly wrong. It’s a high-risk activity and it’s much harder to get right than simply buying and holding (which is tricky enough). Not only are your losses potentially uncapped, but you have to get your timing right. You can’t “sell and hold” – all shorts are short-term trades. And we all know that timing the market consistently is nigh-on impossible.
Small traders will typically do it by spreadbetting (which is high risk and certainly not something you should be doing if you don’t already know all of this stuff). In the institutional world, short selling is left to certain types of hedge funds. These funds look for companies that they think are duds, and will often advertise the fact.
And that brings us to the big story of the day. Professional short sellers having their backsides handed to them by nothing more than small investors clubbing together on internet bulletin boards.
Sticking it to The Man by punting on stocks
GameStop sells video games in the high street (or the mall, given that it’s an American company). This is obviously a terrible business; the pandemic has shut down the high street. But even before that, video games were migrating online – it’s like being a CD shop ten years ago. So, as you can imagine, it’s had a rough few years. At the start of 2016, the share price was nearly $30. At the start of 2020 it was around $6. By summer 2020, it was more like $4.
Now, there was a bit of interest in the stock as a turnaround story in the second half of last year. An activist investor called Ryan Cohen started to show interest in the company, with a plan to ditch most of the physical branches. So by the start of this year, the share price had bounced back up to around $20.
However, lots of short-sellers still believed the company was heading for more trouble. So a lot of professionals were betting on the share price going down (in the jargon, there was a lot of “short interest”).
But now, a month later, GameStop is trading at about $350. That’s a gain of more than 1,700% in a month. What happened? It’s nothing to do with the company actually getting better. What’s happened is that a group of small investors have banded together on social media site Reddit (under the name r/wallstreetbets). This is like a bulletin board, for the old-school investors among you – they all chat about taking punts on stocks, basically.
The prospect of a turnaround at GameStop first attracted them. And then they realised that there was heavy short interest too (in fact, short interest in this stock actually exceeded the number of shares in issue). Then, on top of that, there’s a whole technical situation to do with using derivatives to trade the stock that I won’t go into right now, except to say that it makes the whole thing even more of a tinder pile.
In short, a load of private investors bought in and kept buying, and in the end, both Melvin Capital and Citron Capital – two big, high-profile hedge funds – got kicked out of their positions at huge losses.
Moreover, now that this has paid off so handsomely (well, assuming any of the investors have sold), the world and his wife seem to be looking for companies with heavy short interest against which to mount “long raids”. Or simply hunting for “meme companies”, whereby a big name like Elon Musk mentions a company on Twitter and everyone rushes out and buys it.
Believe it or not, short sellers and hedge funds aren’t really the big baddies
By the way, just as an aside – there’s an idea that this is all about the little guy sticking it to The Man. This is fun to write about, but as usual, hedge funds are the wrong target if you really want to stick it to Wall Street/the City.
Hedgies get all the flak (which is to a great extent the industry’s own fault for cultivating an image of exclusivity and wealth as an exercise in branding). But they’re also the closest thing to an anti-establishment group within the financial industry. Short sellers have uncovered or helped to uncover more fraud than any of our financial regulators have (just Google “Bafin Wirecard” for a right good laugh about that).
And if you’re irritated about the banks being bailed out in 2008 (as some of the posters claim to be), then I’d point out that it’s the banks who were bailed out. The hedge funds were left to go bust (that time around – turns out none of them were as important as LTCM (Long-Term Capital Management, a US hedge fund which almost went bust but was bailed out by the Federal Reserve) in the 1990s.
So if you’re genuinely angry about being unable to afford a house, or about wealth inequality, or whatever you think it is that you’re being shut out of by “The Man”, then the answer is “it’s complicated, but I can tell you for sure that it’s not down to a hedge fund taking a punt on a doomed high street retailer”.
Anyway – now you understand what happened with GameStop. What does it all mean? Honestly, I think it’s just more evidence that the market is getting a bit flakey round the edges, which probably reflects how most of us feel amid the ongoing lockdown. It’s also the sort of rampant retail speculation that you get when there’s too much loose money floating around and you’re getting to the point in the cycle where valuations have become utterly detached from anything you could describe as a “fundamental”.
One of the most interesting things about all this is that while individual stocks were popping up like fireworks yesterday, the Nasdaq, S&P 500, and the FTSE 100 all had some of their worst days in a while. I suspect we’re due a bigger correction. Which will then probably get the central banks involved in the market more aggressively again. And maybe it’ll be triggered by a regulator having a panic and shutting some of this stuff down – I don’t know.
But my advice to you is to focus on your plan, don’t get distracted by tales of one-month 18-baggers, and also make sure you have your watchlist at the ready for when the next genuine buying opportunity comes around.
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John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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