If you think the price of a stock is going to go up, you can buy shares and wait for the price to go up, then sell the shares to someone else. This is called being “long” a stock.
But what if you think the stock price is going to go down instead of up? You may believe the price has run up irrationally high, or your analysis uncovers poor earnings prospects. A favorite tactic of Wall Street pros, including hedge funds, in this case is to “short” a stock.
This means that they sell shares in the stock that they don’t actually own. Suppose the price of XYZ Corp is currently $50. The short seller sells shares of XYZ at $50 into the market, even though he does not own those shares. He is betting that the stock price will go down, so that he will be able to buy back these shares in the open market at a lower price in the future.
He himself does not own these shares, but his broker has located shares that the short seller can borrow and sell for the time being. But at some point the short seller must turn around and buy shares from the market to return the shares to the party from whom his broker borrowed them. This is called covering your short. The behind-the-scenes brokerage mechanics of all this share lending and borrowing are complicated, involving margin accounts and posting collateral, etc. See here for these details.
The key point is that the short seller makes money if the share price is go down, but he can lose money, lots and lots of money, if the share price goes up and stays up. There are all sorts of wry remarks on-line about the “shorts” soiling their shorts when this happens, or being carried out on stretchers, etc.
Folks who do this kind of speculation for a living usually have a policy of limiting their losses. If the price starts to get away from them, they buy back shares to cover, even if it involves taking a modest loss.
One factor that can make the price go up is an intentional “short squeeze”. Here is how a short squeeze works:
When a different group of investors notices that there have been a lot of short sales by a first group of investors against a particular stock, say XYZ, this second group may start to buy large amounts of that stock, with the intention of driving the price up. If some of the shorts lose their nerve, they then buy XYZ to cover, which drives the price up even further. That can force even more shorts to buy the stock at even higher prices (and greater losses to themselves). The squeezers then sell their shares at the inflated prices to the last, desperate shorts. If the squeezers don’t want to commit a ton of capital to actually buying XYZ stock, they can buy call options on the stock; this can cause the options market maker, who sold them the call option, to buy more shares of XYZ as a hedge. This drives the stock up further.
In the end, a short squeeze can cost the shorts dearly. It is great Wall Street theater to see these struggles between shorts and longs. Any stock that is widely seen as grossly overvalued and hence has a lot of short interest is a possible target for a short squeeze. This has occurred repeatedly with Tesla, for instance. The Tesla longs, many of whom are cult fans of the stock, chortle at seeing the Tesla shorts burned (again). So it can get sort of personal.
This all has played out in a dramatic way in the past week with GME, the stock of the video game store GameStop. It seems that on Reddit there is a (mainly) young, restless group called r/wallstreetbets, also known as WSB. They tend to take a YOLO (you only live once), high risk/high reward approach to investing. They are annoyed that big Wall Street institutions get unfair access to things like initial public offerings that the little people are shut out from.
WSB noticed that as of December 31, 2021, the short interest as a percentage of the float for GameStop shares was 260%. Thus, there were many more shares shorted than there were shares readily available in the market. In particular, big hedge funds like Melvin Capital were massively short. The rebellious peasants picked up their pitchforks, in the form of their cell phones, and dialed in a bunch of buy orders for GME, and…it worked!
GME went from ~20 on Jan 12 to ~40 on Jan 21, then started to rise exponentially to close around 150 on Jan 26. The next day, Jan 27, it went vertical, gapping to over 300 at the opening. GME spiked briefly to over 450 this morning (Jan 28), though it rapidly petered down to close under 200. Still, that is ten times higher than it was three weeks ago.
Woo-hoo! The shorts got majorly burned – – Melvin Capital was forced out with huge undisclosed losses, and apparently had to go crawling to two other hedge funds, Citadel and Point72, for a $2.75 billion bailout. The “mob” or “hive” (depending on your point of view) on Reddit is exultant over their epic achievement: “A hive of individual investors f*****g large Wall Street companies, what’s there not to love about this?”
Elsewhere on the internet, comments abound like:
“So you’re saying hedge funds may have to liquidate some of their other positions in order to make up for the losses they took on risky bets while being leveraged? I had no idea you could lose money on the stock market. Dude, you should really tell someone!”
The peasants who bought out of conviction at 20 and 40 and even 100 stand to profit handsomely if they sell when they can. Some will, and some won’t. Because for many WSBers this is more about the principle instead of the money, some are vowing to hang on “till every last short is squeezed out”. I suppose it is something they hope to tell their grandchildren about: “Yeah, kid, back in ’21 we took down Melvin Capital”.
(Sadly, the WSBers don’t seem to realize that, even though the shorts who shorted GME at 20 have long since been squeezed out, a whole new crop of investors are shorting the stock at 200, so the short interest will never go to zero. Shorting at 200 is a pretty sure bet, since eventually the stock will likely drift down close to its original value of 20).
Just when you thought it couldn’t get any more entertaining, Robinhood, the trading platform favored by many of these young, small investors, has restricted buying in GME. They claimed this was to “protect” the retail investors, and themselves, in light of various SEC financial requirements. Some folks in the know believe the rest of the Wall Street establishment has leaned heavily on Robinhood to put the peasants in their places. This obvious unfairness has called forth censure from lawmakers. Alexandria Ocasio-Cortez tweeted, “This is unacceptable…As a member of the Financial Services Cmte, I’d support a hearing if necessary.” In what may be a historic first, Ted Cruz tweeted that he “fully agreed” with AOC.
What’s next? Well, there are other firms that are heavily shorted, and some of the hedgies have to be getting edgy, and may be preemptively covering. One such stock is Macerich (MAC), which owns shopping malls. Its stock was hammered by the Covid shutdowns, since people avoided malls for much of 2020. It has been heavily shorted, and its price movement has mirrored that of GME in the last couple of days (including a spike up on Jan 27), though much muted. Full disclosure: I own a few shares of MAC. Maybe someday I will find myself telling my grandchildren that I squeezed the shorts back in ’21.
Update, Friday morning Jan. 29: Robinhood Back in the Game, Roaring Kitty Outed
After widespread criticism and protests, Robinhood will now allow some buying as well as selling. GME spiked to nearly $500 in premarket action. As of late morning today it is over $300 but dropping.
Two leading voices egging on the buying frenzy in GameStop have been the heretofore anonymous “Roaring Kitty” on YouTube, and “DeepF***ingValue” on Reddit. You couldn’t make this stuff up: “Roaring Kitty takes down leading hedge fund”. Reuters has now found that both of these voices are actually the same person, a 34-year-old financial adviser from Massachusetts named Keith Patrick Gill. A Chartered Financial Analyst, Gill had until recently worked for insurance giant MassMutual.
Gill claims to have invested over $50,000 of his own money in GameStop, and to have (paper) profits in the millions. He was not available for comment, but I suspect we may see him testifying before congressional inquiries before too long.