Most people, when they think of the stock market, understand it to be a place where you buy shares in a company, wait for them to increase in value and ultimately sell them to make a profit. In this case, the buyer is ‘bullish’ because they believe the value will increase.
If the share price loses value, you sell them at a loss, or hold on, hoping for them to eventually recover. That is a basic overview of how the stock market works, but there’s actually a lot more to it. Short selling is the opposite of this, because it involves betting against the company, that’s when the investor is ‘bearish’ because they believe the company share price will fall.
A short seller is a bearish investor. They borrow funds from a brokerage on margin, it’s a high-risk way of investing, but can bring high rewards. That’s why it’s more likely that hedge funds will short stocks, rather than individual investors.
In a nutshell:
- The short seller borrows the stock from the broker, e.g. 1000 shares of GameStop.
- Then sells these shares at the current market rate of $17 for $17k total.
- They set a specific date for when they think the GameStop share price will go down e.g. in one month.
- Then they buy back the stock at the lower rate of $15 for $15k when it falls.
- They return the borrowed stocks back to the broker.
- Keeping the difference of $2k as profit.
While the hedge fund holds the borrowed stocks, they pay the broker interest and commission fees. But if the stock doesn’t fall as predicted, then they’re on the hook for an increasing amount of money. In the case of a short squeeze, if the price escalates rapidly, the broker will demand the shares are returned. This is a margin call and forces the hedge fund into buying back the shares at a much higher price.
The difference between buying and shorting stocks is the amount you stand to lose. While a buyer of a stock can risk their full stake if the stock goes to zero, there is no limit on the amount a short seller can lose.
Risk vs Reward
The GameStop (NYSE:GME) short squeeze is one for the history books, and it’s possibly changed the current stock market setup for good. GameStop, an ailing video game retailer hit hard by the pandemic, was beginning to see light at the end of the tunnel. A few retail investors noticed this too and promoted the stock as a good investment on the road out of Covid-19.
However, major short sellers such as Melvin Capital, Citron Research and Muddy Waters were betting against GameStop surviving, thus pushing its share price down. As more and more retail investors got on board with the idea that GameStop could survive, they squeezed the short sellers into buying the stock. This gradually pushed the price up until the momentum exploded and the share price with it, rallying over 1000% in a matter of days.
And the excitement didn’t stop at GameStop, it soon spilled over into other equities such as AMC Cinemas (NYSE:AMC) and BlackBerry (NYSE:BB), then into commodities such as silver and the cryptocurrency Dogecoin.
When a Redditor spent $2k on GME stock, that’s the most they could lose, but the hedge funds actually lost billions because they were betting the price would go down. When it rose exponentially, their brokers demanded they buy back the shares at the higher price. This pushed GME higher and left the hedge funds nursing losses.
As The Economy Suffers, Stock Markets Soar
There are various viewpoints on how this actually played out and many are dubious that it was as simple as the little guy versus the hedge funds. Perhaps we’ll never know the full story. Nevertheless, it’s been a fascinating eye-opener into the many hands at work in the industry.
The pandemic has brought a whole host of problems to the global economy, yet the US stock markets keep climbing. One viewpoint is that the Fed is to blame for providing unlimited liquidity to the equity markets. Interest rates are low, so people are disinclined to put their savings into the bank where it’s losing money to inflation. But the stock market is appealing because the S&P 500 has gone parabolic in the past year.
It’s a vicious cycle, perpetuated by the Fed. That’s because ordinary people get their stimulus checks from the government, if they don’t need the money to actually survive and they don’t fancy putting it in the bank, then they’re tempted by the markets. Even if they opt for a sensible ETF, then they’re still effectively putting the money into big-name stocks such as Tesla, Apple, Amazon and Microsoft. Buying shares in these stocks makes the rich richer – i.e. Elon Musk, Jeff Bezos and Bill Gates. While, money flooding into ETF’s makes the fund managers richer, i.e. Cathie Wood.
So, what’s the answer? Well the short sellers effectively help the markets keep an even keel. They bet against a stock they believe to be overvalued so that it maintains a fair value, rather than a value based on a futuristic dream of how it should look once X, Y and Z happen.
But the GameStop mania hasn’t done short sellers any favours, if anything it’s frightened them into backing off, at risk of making the markets even more uneven. Case in point Citron Research. The founder and well-known short-seller Andrew Left was ridiculed and harassed on social media for the part he played in shorting GME. It culminated in threats on his life and he quit Twitter, following up with the announcement that he’s stopping publication of short reports and moving to focus on, “multibagger opportunities for individual investors.”
A Ruthless Industry
That’s not to say they’re all the good guys and we should be shedding tears for them. We shouldn’t. The stock markets are a complicated playground with ruthless activity. It’s not for the faint-hearted and shouldn’t be taken as a route to easy money. There are many hands at work, and some are actively involved in the pump and dump strategy of pushing a price up to astronomical highs, only to sell out and leave the latecomers to drown in losses.
Andrew Left himself has been involved in numerous court cases. That’s understandable given the nature of his business, but what concerns many is his past. In the late nineties, he worked at trading firm Universal Commodity Corp. and was sanctioned by the U.S. National Futures Association. He was barred from acting as a principal in the industry for three years and ordered to take an ethics-training course after it found Left had “made false and misleading statements to cheat, defraud or deceive a customer in violation of NFA compliance rules“.
It’s not just traditional stock buyers that don’t like short sellers. One reason they’re hated is that some have been known to deliberately spread false rumors to profit when stocks fall. Short selling is not as closely regulated as the rest of Wall Street, so there’s room for nefarious activity. Short sellers have been known to conspire to drive share prices down, destroying good companies in the process and causing ordinary folks to lose their jobs.
Elon Musk has called for shorting to be banned. Many others have said shorting a stock and publicly recommend selling it should be made illegal. It seems the GameStop debacle is inviting closer scrutiny of the entire stock market setup, so changes may be in the offing.
Shorting Is Not All Bad
Jim Chanos of Kynikos and George Soros are among the world’s most famous short sellers. Chanos helped expose Enron and Soros bet against The Bank of England when he shorted the British Pound. In recent years the film The Big Short brought Michael Burry to fame (Ironically, Michael Burry was actually long GME). Then there was David Einhorn, who shorted Lehman Brothers.
In recent years there have even been Netflix documentaries made about short selling such as Dirty Money and The China Hustle. In both of these they showed short sellers acting like private investigators and uncovering major frauds. Surely, it’s in the interest of everyone that this kind of work continues.
SPAC investing has become another area of interest for short vs long activity. SPAC stands for special purpose acquisition company, and it allows a private company to go public with little scrutiny. There was an explosion in SPAC investing in 2020 and it’s set to grow even more rapidly in the coming year. King of SPACs Chamath Palihapitiya has brought many exciting companies public in this way, but people are getting concerned that it’s a breeding ground for the pump and dump.
One short seller Hindenburg Research brought out a report last week outlining a negative view of health-care software maker Clover Health Investments (NASDAQ:CLOV), which is one of Chamath’s highly promoted SPACs. Whether they are right to be concerned or not remains to be seen, but many investors believe they have the right to know the information outlined in the report and are glad of the service short sellers like Hindenburg provide.
Signs To Look Out For To Avoid A Pump And Dump
As a retail investor, it’s important to be aware of the pitfalls in the marketplace and some signs to look out for:
- The phrase ‘To the moon’ is notoriously linked to cryptocurrency pumps and increasingly popular stocks too. While many use this phrase for a laugh, it could also be a warning sign that a stock or crypto is being pumped.
- When everyone and their auntie are discussing a stock, it’s probably reaching saturation point.
- It’s much easier to pump and dump a penny stock than a highly established stock.
- A significant spike in volume and price on a chart, prior to you hearing about the stock, is a clear sign that you could be entering pump and dump territory.
- Major news can create interest in a stock, but if there’s nothing of note in the news and a sudden increase in volume, then that can be a red flag.
- Nothing is guaranteed, so anything promising you riches beyond your wildest dreams is probably a scam.