TANA-NOMICS: Short Selling

TANA-NOMICS: Short Selling


Have you seen these stories about the US company GameStop, a chain of video game stores and distribution centers, and the fact that small retail investors have banded together to “stick it” to institutional investors, namely hedge funds, who’ve been short selling GameStop shares?

Wow, there’s a lot of concepts packed into that one paragraph so let’s “back-back on it” like it’s Carnival Tuesday and unpack it a bit.

Ok, so a hedge fund is a financial institution that pools investors funds and deals in alternative investments using complex investment strategies (all legal) for the common good of all the investors. Hedge funds are typically only available to high net worth, accredited, sophisticated investors who not only have lots of cash but should also understand the risks involved. I say should because not all do. There are all manners of hedge funds named after the particular strategy employed by that is beyond the scope of this post.

Short selling has nothing to do with individuals under 5 feet 7 inches engaging in commerce and enterprise. Yes, I chose that height cut off for personal reasons (fight me!). No, short selling is when an investor borrows a stock from other investors, sells it, and then buys the stock back (hopefully at a lower price) to return it to the lender. The investor profits when the price they sold the stock is above the price they have to repurchase it at to return to the lender.

Naturally this is a strategy you would use when you expect a stock to decline in price. Let me “maths-it-up” a bit to drive the point home. Let’s say the price of shares in Galoob, the company that made “The Animal” back in the 80s, was trading at $100. Now if you believed the stock to be overpriced (I don’t know why because we all know “nothing can stop, The Animal! Each sold separately, batteries not included.”), you would contact your broker to borrow the stock from someone who owns it, sell it in the market at $100 and if it fell to say $50, you could buy it back at $50 and return it to the lender. Boom! You’ve just made $50 (ignoring fees) on a stock declining in value. Not too shabby.

The risk with short selling is what happens when the stock goes up in value. In a straightforward stock purchase (as in you didn’t borrow money to buy it aka use “leverage”) you can never lose more than you invested. That’s because shares can only fall to $0. Therefore with a $100 Galoob share you can only lose $100. However, when you sell short your losses are potentially infinite as there is no limit to how high a stock can appreciate. So picture short selling “The Animal” at $100 (because you’re not too smart) and watching the stock rise to $500 when it’s time for you to return the shares you borrowed. This clearly goes against my investing mantra of….wait for it….”buy low, sell high”.

Well, this is exactly what happened to the hedge fund Melvin Capital that bet against GameStop and shorted their stock. A band of small traders and investors, meeting on forums like Reddit and trader-focused forum WallStreetBets bid the price of GameStop up over 1700% in a month. The hedge fund was forced to close out its position and losing billions (with a B) for its investors.

This is known as a “short squeeze”, which is when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to prevent even greater losses. This short squeeze is not to be confused with the enthusiastic hug you would give your diminutive, hot “smallee” friend when you bounce her up in a cooler fete.

The actions by these investors have spread to European and Asian markets and of course now the regulators are looking at this phenomenon as they typically don’t like market collusion. Still, investors are on the look out for the next GameStop with names like Nokia and Blackberry being considered given the amount of short selling in those names. For me, if they could bring back those two I wish they would try it with the companies that made Bata and Travel Fox next.

TANA

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