Short selling on the stock market came to the forefront of our attention in late January, when GameStop shares, which were expected to drop, actually surged.
We will find out why this caused panic and uproar, and how you can never be sure how the market will play out.
We will start with explaining what Short Selling is, then we will go into what happened with the surprising GameStop surge.
What is Short Selling:
In a nutshell, the short seller profits by selling borrow stocks at one price and repaying the stocks from the same stocks purchased at a later date at a lower price.
- A hedge fund or other short seller borrows stock from a broker, that he/ she believes will go down in value.
- Once borrowed, the stock is sold on the market.
- When the price goes down, stocks are re-purchased.
- The shares are re-paid to the broker.
- The difference in price between selling and buying is the short sellers profit.
Short selling (also known as “shorting,” “selling short” or “going short”) refers to the sale of a security or financial instrument that the seller has borrowed to make the short sale. The short seller believes that the borrowed security’s price will decline, enabling it to be bought back at a lower price for a profit. The difference between the price at which the security was sold short and the price at which it was purchased represents the short seller’s profit (or loss, as the case may be).
Why does short selling have a bad reputation?
And is it any different from raising stock value artificially?
Short selling is considered unethical by some as on the surface it seems likes a cruelly opportunistic method to gain profit, on top of betting against the economy. However proponents posit that short selling helps provide liquidity as well as helps temper overvaluation.
Supporters also like to point out that betting on companies to lose value isn’t really all that different on betting that they will increase in value.
So what happened with the GameStop windfall in (late) January?
In early January 2021, there were signals that GameStop shares were slowly rising, for 2 main reasons.
Firstly, GameStop, a beloved but beleaguered video game exchange retail chain, had been doing worse and worse over the last few years, with almost 800 stores of 6000 nationwide shutting down in the last 2 years.
So, although the value was low and the chain looked doomed, there was support from a reddit group named WallStreetBets that wanted to support the underdog and see if they could beat the short sellers at their own game, by increasing the value.
The second point is that on top of the nostalgic value, and opportunity for disruption, there were signs, as early as November 2020, that GameStop could be making a turnaround.
- During the 2020 Holidays, retail sales dropped but online GameStop sales (1/3 of total) increased 300%.
- In November 16, 2020, Chewy Pet Food Products Founder Ryan Cohen signaled he would be joining the GameStop Board of Directors.
- Over the holidays, GameStop created a new partnership with primary stakeholder RC Ventures, of which Cohen is also a director.
Using these organizational changes as beacons of hope – and half in jest- the reddit community WallStreetBets began investing heavily in mid January, looking to make a profit while watching the hedge fund traders lose out.
- Up until Jan 5th, shares were valued at around $17 USD.
- By Jan 14, closed at 39.91 USD, then Jan 22st at 65.01 USD. Then on Jan 25th the stocks started soaring, peaking at over $400 USD on Jan 27th, when the trading was restricted, closing at $347.51.
- Since restrictions were eased last Friday, GME stocks are sitting at $59.20 USD as of Feb 5, over 3 times their value a month previous.
The surprise rise in underwhelming players didn’t stop with GameStop. AMC Entertainment, American Airlines and more all saw unexpected increases as WallStreetBets bought in mass before the trading platform RobinHood placed caps on trading.
“Most of GameStop stock gyrations have to do with a tug of war between amateur day traders on Reddit, one of the world’s largest online communities — who are betting on the stock to keep rising — and the professional managers of Wall Street hedge funds, who have bet that GameStop’s stock will crater.
Why was the restriction on GameStop shares controversial?
The temporary GameStop trade restrictions by trading house RobinHood on Thursday January 27th , was a reaction to the soaring Gamestop stock value, stock that was up to that point seen as overvalued and thus heavily invested by traditional short sellers, looking to profit off of its continued fall.
When the opposite occurred and prices skyrocketed as more and more shares were purchased, both by “amateurs” and short sellers needing to buy more shares to cover their prior investments, the trading was restricted, much to the ire of the amateur reddit community behind the valuation thrust.
There were a couple layers of irony in this event.
The first is that short selling is traditionally considered only marginally acceptable by some.
The second is that the very same traders who profit off of the loss and failure of corporations temporarily capped trade to prevent themselves losing more money, as one of their chosen stock (GameStop) suddenly showed positive growth, and made money for trading outsiders.
One (Reddit) member suggested that the Reddit traders were part of a resistance movement of sorts, writing, “[T]his is not a war on billionaires, the wealthy yada yada, but it may well be described as a resistance against injustice, inequality, rigged rules, uneven playing field etc which has been rampant on Wall Street forever.”
Politicians on both sides were quick to criticize the trade restrictions, as unfair to “amateur” traders looking to make money off of increased stock valuation. The amateurs were fairly making a profit, albeit at the expense of the traditional hedge fund (Gamestop) short sellers.
Also, some politicians are using this event as a way to push for more regulations on the traditional short-seller. The Securities and Exchange Commission is “aware of and actively monitoring the on-going market volatility”.
Different strokes for different folks.
The GameStop GME Short Sell Windfall of Jan 2021 shows the volatility of the market and how it can often go in opposite directions than planned by “status-quo” investors.
And, just as growth stocks can be over-valued, so can they be under-valued -all for profit.
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