Financiers are reeling after a Reddit subgroup called WallStreetBets encouraged users to buy up stock of video game retailer GameStop, which they noticed professional hedge funders had bet heavily against using a technique called shorting.
The surge of buying caused the stock price to jump exponentially, giving some Redditors obscene profits while hedge funds lost millions. The process is now repeating with other sinking stocks — including movie theatre AMC, BlackBerry and more. (Shares have since plunged after several online platforms imposed buying halts on Thursday, prompting outrage and accusations of unfairness).
How did this happen? And what does the GameStop stock surge mean for your investments? Here, we break down the basics of the short sale, and how they’re affecting the markets.
What is a short sale?
A short sale is a trade you would execute backwards. In other words, you start by selling the stock, and then try to buy it back later on. You short a stock when you think that a company’s shares are overpriced, in order to buy it back at a lower price.
Shorting is always a bit of a gamble. When selling a stock that you do not own, you have to borrow the electronic certificate in order to deliver it to the buyers on the other side of the trade. If you can’t deliver, you might be forced to buy them back at any price. Additionally, when borrowing stocks, you also have to secure a margin requirement keeping cash or other values in your portfolio. The margin gets bigger when the price of the stock you sold short goes up in value. You risk your margin requirements becoming too big for you to handle.
When you short a stock, you theoretically face an unlimited loss. You could be forced to buy back the stock at the prevailing market price, whatever that may be — and risk losing a huge amount of money.
What is a short squeeze?
A short squeeze happens when you can’t borrow the shares or have a hard time keeping up with margin requirements — or often both.
In the case of GameStop, approximately 130% of shares of the company were shorted. That means that for every share in circulation, there were 1.3 shares sold short. It’s not hard to imagine Wall Street investors scrambling to find stocks to borrow, making easy prey for a major short squeeze if this price was to pick up.
What makes this different is the sense of higher purpose and collective effort on behalf of the Reddit community. Together, they banded together to fight the deep pockets of the short sellers, giving them a good old run for a short squeeze by making the price go up wildly.
What does the surge in GameStop stock mean for my portfolio?
What we are seeing right now is a good old game of chicken. Imagine two cars speeding into each other, daring to see which driver will be the one who turns first. That’s what’s happening here. Eventually there will be a crash, and some serious money will be lost.
Like a good game of chicken, it can be an interesting show to watch. But we advise caution. For one thing, this phenomenon is unlikely to last. Small investors have chased popular investments before, and will likely do so again. But the tried-and-true equation for success in the stock market remains the same: Opportunity = homework + volatility. You must do your homework ahead of time to avoid defensive or hasty decision-making in volatile markets. That way, when volatility arrives, you will be able to recognize your moment of opportunity.
As always, we at Claret encourage a slow-and-steady approach to investing. Focusing on long-term returns and holding a well-diversified portfolio is the best way to protect yourself against unpredictability/volatility.
We’ll continue to follow this story closely as it unfolds, but one thing is certain: digital technology is changing how the markets operate in unexpected ways. Your portfolio manager can help you navigate this brave new world, maximizing your investments in the face of unpredictability.
Vincent Fournier and Chris Kovalchuk