A Primer on Short Selling, the Short Squeeze, and Why BetterInvesting Does Not Recommend Getting Involved in This Type of Market Game Playing.

In case you missed all the ruckus in the news involving the short squeeze of GameStop (GME) stock (among others) here’s a recap.

In the final weeks of January 2021 a group of traders coordinated an effort to drive up the price of GameStop shares for a variety of reasons – one being to send a message to the Wall Street elite that they are not the only players in the market. Driving the price of the stock up is exactly what they did. GameStop shares went from just less than $40/share on January 20 to just over $347 share on January 27. The share price has been volatile ever since with a closing price of $92.41 at the time of this writing on February 3. This share price increase was not based on an improvement in company fundamentals, improved business performance, or a bright outlook for the company. This action taken by the group of traders was mainly to have a devastating effect on those individuals and institutions (hedge funds, etc.) that had shorted the stock, and they did so by setting off what is called a short squeeze. You might be wondering how an increase in the company’s share price could be a bad thing.

Let’s take a closer look at both short selling and the short squeeze to help us better understand the situation.

Short selling a stock is a trading strategy that speculates on the decline in a stock’s price. It’s a strategy that should only be utilized by experienced (and some might say pessimistic) traders. Typically with short selling, a trader opens a position by borrowing shares of a company from a broker-dealer. To open a short position, a trader must have a margin account that allows investors to borrow money to buy securities. Traders will typically have to pay interest on the value of the borrowed shares while their position is open. To close a short position, a trader buys the shares back on the market and returns them to the broker-dealer. Their hope is that the price paid for the shares to close the position is less than the price they borrowed the shares at. The difference between the amount borrowed and the amount paid to close the position reflects the profit or loss experienced by the trader. Interest charged, commissions and other charges must be taken into account by the trader as these will eat into the potential profits or increase the losses depending on the situation.

Let’s take a look at a couple of examples.  

Example 1:

A trader believes that a stock currently trading at $100/share will decline in price in the next two months. The trader borrows 200 shares of the company from the broker-dealer and sells them to another investor. The trader is now short 200 shares of the company since they sold shares that they borrowed. There’s no guarantee that shares of a company will always be available to short due to the number of shares already shorted by other traders.
Five weeks later, the company shares that were shorted had declined in value to $50/share. Seeing a nice profit, the trader decides to close the short position. To close the position the trader buys 200 shares for $50/share on the open market to replace the shares borrowed. The trader’s profit on this short sale, is $10,000: ($100 - $50 = $50 x 200 shares = $10,000). Interest charged, commissions and other charges must be taken into account to arrive at the true profit.

Example 2:

Let’s use the same scenario in example 1, but this time the company shares that were shorted increased in value and continue to show promise of additional share price increase. The share price has increased to $140/share. The trader decides to close the short position to head off the potential for further loss. To close the position the trader buys 200 shares at $140/share on the open market to replace the shares borrowed. The trader’s loss on this short sale, is $8,000: ($100 - $140 = a negative $40 x 200 shares = loss of $8,000). Interest charged, commissions and other charges must be taken into account to arrive at the true amount of loss.

As you can see by the examples there is the possibility of making a good profit, but the risk of loss on a short sale is theoretically unlimited since the price of any stock can increase and increase without limit.

When it comes time to close a short position, the trader could have trouble finding enough shares to buy on the open market if there are a lot of other traders shorting the stock, if the stock is thinly traded to begin with – not many shares being transacted, or the stock is being purchased by momentum investors looking to profit on the unexpected run up of the stock price. When this happens sellers can get caught in a short squeeze loop if a shorted stock starts to greatly increase in value.

Let’s examine what a short squeeze looks like.

A short squeeze can happen when there is enough increased demand for a stock that also has a lot of sellers making short sales. In a short squeeze there are long buyers and the short sellers. This scenario creates the ideal environment of factors that push stock prices higher and higher over a short period of time. Momentum investors are buying the shares, which forces the short sellers to buy the stock in an attempt to cut their losses. As they buy, this drives the price even higher.  And often a stock with a troubled future that attracts a short seller will have minimal trading volume, so small changes in demand can move the price dramatically. 

As discussed, short sellers open positions on stocks that they believe will decline in price. However rational and logical their thinking is, it can be upended quickly. In the case of GameStop the group of traders was the factor behind the short squeeze that the short sellers of GameStop shares didn’t see coming. Many of the short sellers in this case had placed large bets that the price of GameStop would fall. They were justified in their thinking by the poor performance of GameStop. The fundamentals of the company tell the story. Many of them realized huge losses.

In general, selling short can be costly if the seller speculates wrong about the price movement of a stock. Investors who buy stock can only lose 100% of the money invested if the stock moves to zero, but the risk of loss on a short sale is theoretically unlimited.

Speculating on the decline of a stock’s price is what makes this type of short-term strategy the direct opposite of investing in good quality stocks for the long term as BetterInvesting has taught its members for over 70 years. In the long term a company’s earnings and fundamentals are the key drivers of stock price appreciation. Beginning investors should avoid the risky games played in the stock market, and turn off the noise and distraction of the minute-to-minute reporting and focus on fundamental stock investing. The BetterInvesting style of investing has, and always will, focus on the ability of company management to generate strong and consistent earnings over long periods of time.  And for that the long-term investor will be rewarded.

Written by:  Dennis Genord, Director, Education and Chapter Relations, BetterInvesting

Dennis Genord has been a BetterInvesting member for 25 years as a partner in three different investment clubs. He also leads organizational efforts to develop and deliver in-person and online investment education to BetterInvesting members and investment clubs. He helped develop the Building Wealth Curriculum that focuses on financial literacy and fundamental investment education, and he continues supporting teachers using the curriculum in high schools across the nation.

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