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The GameStop debacle is the talk of the town, but what are the risks associated with short selling? Our investing expert takes a closer look at hedge funds and short selling stocks.

The GameStop debacle was the perfect investing news story to kick off a chaotic 2021. The event made many people rich, others bankrupt, and left virtually everyone dazed, confused, and wondering what just happened. It also has ushered in a hilarious new era of “meme stocks,” much to the dismay of regulators.

If you’re still wondering what exactly went down, you’re not alone. You may even be asking, what is the purpose of short selling stocks? The events of GameStop were theatrical but highly complex. To understand what happened you need to understand hedge funds, short-selling, and internet trolls. Thankfully, I’m well-versed in all three. Let’s start with the basics before deconstructing this stock market “dramaedy” in-depth.

How Does Short Selling Stock Work?

Short selling is a common active trading strategy used by experienced and professional traders to make money on stocks (like GameStop) that are decreasing in value. It involves borrowing shares from your broker, selling them on the market at the current price, then buying them back and returning them to the broker after they have decreased in value.

In other words, you “sell high, buy low” instead of the traditional “buy low, sell high”. Your profit is the difference in value between the high price at which you sell the stock and the low price at which you buy it back.

Is short selling high risk?

Short selling is considered a form of high-risk trading because the short seller can theoretically face infinite losses. When a trader shorts a stock, they expect it to decrease in value. However, if it increases in value, every dollar it goes up in price is a dollar the short seller loses. Because there’s no maximum price a stock can reach, there is no maximum loss a short seller can face! This is much riskier than simply buying and holding stocks, where the biggest risk you can face is your investment going to zero.

Do short sellers make money?

Experienced short sellers tend to make money on their trades, but no one makes money on every trade. Professional traders, like the analysts that work for hedge funds, accept occasional losses in short selling because they typically win more often than they lose.

The Problem with Short Selling Stocks

Short selling is hard to understand, but easy to do, which is why some less experienced investors can rapidly lose a lot of money. Even experienced traders can get into trouble with short sales when they take on more risk than they can actually handle. Often day traders and portfolio managers will take short selling a step further and use options or borrow cash on a margin for leverage. It’s hard to believe you can make a trade with potentially unlimited losses even higher risk but borrowing money or using derivatives (or both!) to short a stock is a way to do so.

Active traders should have the good sense to put stops in place to mitigate losses if a trade starts to turn bad, but sometimes the simplicity of short selling can make it easy to neglect to protect your downside – especially if you’ve been consistently shorting a stock for years with no bad outcomes!

A look at the GameStop fiasco will give you a glimpse into some of the problems with short selling stocks.

What happened with GameStop

GameStop (GME) is a videogame console and game manufacturer that’s been operating since 1984. The company went public on the New York Stock Exchange in 2002. Over the years the stock price hovered around $10 per share, peaking once at over $62 in 2007 and again just under $57 in 2013. Since 2013, the share price of GameStop has been in decline.

GameStop has struggled to remain competitive in an increasingly mobile world, where people will simply download games on their phone instead of purchasing a console for their home. While the company was holding its own, it wasn’t expected to turn a profit until 2023. Hedge funds had been trading GameStop for years, and in witnessing its predictable decline, shorting the stock for the better part of a decade.

Hedge funds were shorting GameStop for years

A hedge fund is a private firm that pools capital from wealthy investors to pursue aggressive investment strategies. Because of the nature of their strategies, hedge funds are typically only accessible to accredited investors who can afford to put hundreds of thousands (if not millions!) of dollars into the fund.

Hedge funds regularly make use of financial derivatives, leverage, and short selling to maximize investment returns. These tactics are high-risk for the average investor, but the analysts at hedge funds are expert traders with lots of capital to move around. Losses do happen but usually are outweighed by large gains on other trades.

Hedge funds were making consistently good returns by shorting GameStop for years. It was such a reliable way to make money, they were shorting tens and sometimes hundreds of thousands of shares at a time. In fact, at one point more than 140% of GameStop’s available shares were being lent out in short sales. Unfortunately for the hedge funds, Reddit noticed. When GameStop happened, the losses on this single stock pushed many hedge funds to the brink of bankruptcy.

How Redditors took down the hedge funds with GameStop

WallStreetBets (WSB) is a small investing subgroup on reddit that saw an opportunity with GameStop. Starting nearly 2 years ago, WSB Redditors were making a case for taking a long position in the stock. They were mostly ignored and the share price of GameStop continued to decline, until well-known opportunistic investor Michael Burry (of The Big Short fame) said he was long GME in his fund, Scion Asset Management.

Jokes started to be made in WSB that they could take over GameStop themselves. It was far-fetched, but still possible that the pooled investing capital of the Redditors could do it if they all went in.

The WallStreetBets subreddit weren’t the only investors that could see vulnerabilities in GameStop stock. By the summer of 2019, Burry had Scion management issue a press release urging GameStop to buy back $238 million in shares. Other large online investing publications also warned about the dangers of shorting GameStop. The shares began to climb, and by April 2020, Redditors saw their opportunity and initiated a takeover.

First, they bought up more and more GameStop stock. Then they called their brokers and said they did not want their GameStop shares to be lent out for short sales. The price of GME shot up 22% in a single day, then another 26% the day after. It was the largest gain since the company went public, and it kept climbing.

The combination of buying up shares of GameStop and refusing them to be lent out for short sales created what’s known as “short squeeze.” The hedge funds who had shorted GameStop were forced to cover their positions at a loss, buying back the shares at far higher prices than they had sold them for. However, buying the shares back further increased the stock price, which forced even more short sellers to buy at bigger losses and so on. The result is a positive feedback loop that keeps squeezing the stock price higher and higher.

Retail investors signed up for a rollercoaster destined to crash

When news broke about what was going on, retail investors piled in. Many amateur investors didn’t understand what was happening, but they heard “GameStop” and saw the price of shares skyrocketing, and figured they needed to get in while they could.

The US low-commission trading app Robinhood temporarily suspended trading of GameStop on their platform and mutiny ensued. Existing and new users who wanted to get in on the GameStop mayhem launched a class-action lawsuit against Robinhood for restricting access to the stock market. Trading was restored in less than a day, and investors cheered for their chance to hop on the bandwagon.

Unfortunately, these are likely the people who will suffer the most as GameStop’s price crashes back down.

This is not a story about taking down the rich

As the events played out in the news, many people saw this a heroic uprising against capitalism, where small investors took down the wealthy elite. Unfortunately, that’s not exactly what was happening. Instead, the hedge funds received bailouts, the Redditors took their profits at the top, and retail investors were left holding the bag.

After hitting an all-time high of $483 on January 28th, 2021, GameStop was worth less than ¼ of that only a week later. We can expect the stock to continue downward until it reaches its fair valuation under $10 per share.

The ultimate irony? Hedge funds who managed to hold on to their short sales, or elected to short even more shares of the stock at the top, will now profit on exactly what they intended: the price of GameStop going down. So much for taking down the elite.

The era of the meme stock

As the GameStop short squeeze played out, Redditors looked for similar opportunities. Dozens of low-priced stocks like AMC, Build-a-Bear, Blockbuster, and Blackberry became short squeeze targets of social media mobs. The more the news reported on these stock prices surging, the more people got on board and manipulated the prices further. They were now meme stocks.

A “meme stock” is a stock whose price is significantly impacted, if not wholly determined, by people online. In the case of GameStop, and the other stocks that followed, the price per share had very little to do with the underlying value of the company and virtually everything to do with the hype online.

Stock price manipulation is as old as the stock market itself, but it’s never been done by internet trolls and regulators are scrambling to deal with it. Our new digital age of social media and mobile discount brokers with little account minimums have made communications and investing easier than ever. But this also introduces new kinds of risk.

The Lesson For Investors 

Professional and amateur traders alike learned many lessons about risk, greed, and loss with GameStop. Whether you were caught in the foray or stayed on the sidelines, you can use this event to inform your own investing approach.

The biggest takeaway? High-risk investing in single securities is best left to people with money to burn. For the rest of us, building a portfolio of index funds or ETFs or using a robo-advisor is the best way to ensure a solid return while protecting your downside. The only thing you should buy from GameStop is a videogame.

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