What Is Short Selling And What Was The Gamestop Incident?
The GameStop incident in 2021 shed light on short selling and helped us finally understand what Bobby Axelrod is actually doing in Billions.
This trading technique became popular when Reddit started fighting Wall Street, and finances got a lot more interesting.
We’ll tell you what happened with GameStop and why you can’t count on short-selling below.
The GameStop Incident
Here’s how this beautiful mess began:
GameStop is a video game company, and Melvin Capital, a hedge fund, advised its readers on short-selling its stocks.
Short selling means speculating on the price of stocks. Here’s how you do that:
You rent stocks from a broker and give them back after a certain period. You then sell those stocks and repurchase them before that period ends. If the stocks’ prices decreased, you’re in luck. It means you can buy more for the same money and keep the profits.
Enter Reddit’s Wall Street betting people. These geeks love market speculating and dabble in all sorts of crazy investing strategies.
It’s no wonder these Robin-Hood-like redditors suddenly decided to fight against Melvin Capital.
After all, they thought, why should giant companies always get to mess with ordinary people?
So, these people decided to increase stock prices. They mobilised each other and bought lots of stocks. They managed to raise stock prices about ten times over, from a measly $20/stock to over $200/stock.
Therefore, Melvin Capital’s Billions-worthy hedge fund lost, well, billions.
Enter Point72. This is another hedge fund that saw that Melvin Capital was on the brink of bankruptcy. As a true friend, Point72 decided to help their friends at Melvin Capital with $3 billion.
Guess what the redditors did?
Yes, they increased stock prices more.
And Melvin Capital ended in the dump.
Enter the media. News of this entire debacle brought more random investors into the scheme, and GameStop suddenly became top of the trade market at the end of January.
Next, brokerages started to stop trading their stocks, much to the investors’ outrage. And that means GameStop stock prices have fallen even more.
Moral of this story: when Reddit gets involved in the trade market, real-life becomes as exciting as TV shows.
Why Is Short Selling Risky?
The GameStop incident suggests why short selling is risky. After all, you’re betting on stocks that aren’t your own without knowing who might want to screw you over.
Here’s the formal way of putting that:
1. You’re Betting On Borrowed Stocks
Short selling means borrowing stocks from a brokerage agency. If you believe their prices will drop before you have to return them, you’re selling those shares.
However, you’re only profiting if you can buy back those stocks at a lower price.
Info: Trading borrowed funds bears the name of margin trading.
Before giving you a loan, brokerage agencies demand a cash advance. They’ll also impose interest rates and late fees because that’s how loans work.
So, if you’re buying back those stocks at a higher cost, you’re not just losing the price difference. You’re also losing the money you paid for the advance, the accumulating interest, and potential late fees.
2. You Could Lose Everything
Regular investing limits your losses to the money you actually invested.
For instance, if you invest $1000 in a bogus company that goes bankrupt, you’re only losing that $1,000. That’s not amazing, but it’s not the worse that could happen.
Instead, short selling is the epitome of high-risk trading.
In the case of GameStop, Reddit raised share prices about ten times. If you were to short a GameStop stock at $1000, you would lose $9,000. That’s what you get if you subtract $1,000 you won from selling your share from the $10,000 it currently costs.
And that means you can lose nine times as much as with regular trading.
The problem is that your losses aren’t capped at nine times.
No one can foresee how much a stock price can rise, which means you can lose twenty or a hundred or a gazillion times your initial sum.
Therefore, newbies should steer clear from high-risk short selling. Remember that margin trading poses increased risks compared to vanilla trading because it pushes you to trade money you don’t have.
3. Short Squeezes Can Mess With Your Plans
GameStop looks like a modern remake of a bunch of Aesop’s fables. The moral of this story is that you never know who might hate you enough to mobilise an entire Reddit community against you.
Sure, Melvin Capital did its due diligence researching GameStop. Their trading strategy was top-notch because it accounted for 99.999% of all the things that could happen.
The one thing they missed is that we now live in the Internet era.
Therefore, Reddit rogues will find out what you’re doing. If they feel like you’re harming them or that your actions are immoral, they will take action.
After all, who doesn’t want to teach The Man a lesson?
Now that these platforms are becoming so cohesive and strong, you can expect short squeezes to happen more often. Previously, short-squeezes were rarer because you couldn’t bring together so many determined people willing to invest their funds for an idea.
But here’s the thing:
You don’t always need a synchronised mass of trolls to short squeeze your stock prices.
Many unpredictable factors in the environment can plummet demand and, therefore, lead to lower stock prices. One of the best recent examples is the COVID-19 pandemic that caused enormous losses for the hospitality and travel industries.
You know now that short selling is off-limits if you’re not an expert. Or have lots and lots of money.
You’re also probably wondering if you should invest in GameStop. Technically, you could, although trustworthy Singapore brokers are stopping those purchases.
Therefore, you’d need to find a less reliable broker to dip your toes into what looks like a whirlwind of risks.
Instead of dabbling in margin trading in the hopes of quick heaps of cash, find a sounder investment strategy like ETFs or REITs.