The coordinated effort by users of the online forum Reddit to drive up the share price of GameStop and other companies is designed to turn the screw on short-sellers. Rob Davies reports.
To the layman, the dynamics at play here can seem dizzyingly labyrinthine.
But a good place to start is by understanding what short-selling is – and how the Wall Street wizards who do it could end up being wrong-footed by a group of amateur traders.
What is short-selling?
It’s a way of making money by betting that a company’s share price will fall.
Let’s say StuffCo (a made-up company) has a share price of £10. If I believe the share price is going to rise, I’ll simply buy shares at £10. If the price rises to £15, I can then sell my stock for a profit of £5 per share. Shorting is a little more complicated.
If I expect the share price to fall (because I think it is a rubbish business: badly run, for instance, or selling outdated products), I can borrow a share in StuffCo from someone who has it, in return for a small fee. If I sell it straight away, that puts £10 in my pocket.
I no longer have the share I borrowed but I will have to give it back at an agreed time. So I wait for the StuffCo share price to fall to £5, then buy it and return one share to the person I borrowed from in the first place.
They get their share back and I’ve still got the £10 I sold it for, minus the £5 I had to pay to replace it. I have pocketed £5 by correctly anticipating the fall in the share price.
What can go wrong?
If my prediction is incorrect and StuffCo’s shares go through the roof, I’m in big trouble. I’ve sold the share I borrowed at £10 but if the value increases to £100, I’ll have to spend £100 in order to give a share back to the person I borrowed from. I’d lose £90.
Theoretically my losses are unlimited – because there is no defined ceiling on how far a share can rise.
What has happened with GameStop?
In this case, Reddit users in a group called WallStreetBets noticed that hedge funds, including one called Melvin Capital, had taken a large short position in GameStop. They decided to punish the Wall Street big boys and launched a coordinated buying spree. That began forcing the price up – it is now up more than 1800% – increasing the losses for the short-sellers who had bet against it. They had suffered losses of $1bn already, according to reports on Thursday.
The hedge funds found themselves trapped in what is called a “short squeeze”, a kind of feedback loop that drives the price ever upwards. The hedge funds have to start buying the shares, in order to “cover” their position and limit their potential losses. But that buying forces the share price up even more – making their position even worse. Effectively they have been forced to bet on shares rising in order to offset their previous bet on them falling.
How can Reddit users afford the buying spree?
They aren’t only buying shares, they’re also using call options. These are the right to buy shares at a certain price and they effectively function as a leveraged bet, a purchase that only requires you to pay a fraction of the share price. This is the fuel that stokes the short-squeeze fire.
Do short-sellers deserve it?
Hedge funds aren’t exactly the world’s favourite people, given that they make vast quantities of money, often with ruthless disregard for the businesses that become little more than chips in a financial casino game.
During the financial crisis, shorting became a byword for vulture capitalism. Hedge funds were accused of deliberately driving companies into the ground by taking out billion-dollar short positions, artificially pushing down share prices to the point that they collapsed, when they might otherwise have survived.
Several national financial regulators across the world imposed temporary bans on short-selling certain vulnerable stocks – such as banks or insurers during the post-2008 financial crisis – or even blanket bans on the practice.
Is the criticism fair?
There is evidence that shorting can accelerate the downward movement of share prices, as big bets on corporate failure become a self-fulfilling prophecy.
The counter-argument is that you cannot successfully short a healthy company, as your bet will simply turn out to be wrong.
Furthermore, short-sellers can act as an early warning system highlighting bad businesses. They have often proved to be the first people to notice that a company is in trouble, sometimes even before the company’s directors do. Investors took out large short positions in the government outsourcer Carillion before its high-profile collapse.
In the recent Wirecard scandal, short-sellers realised the German company was built on sand, even while Germany’s financial regulator continued to bury its head in the sand. – The Guardian