GameStop: The Long and Short of It

So what’s going on with GameStop? This blog will explain for the novice what all the hype is about. To begin, let’s talk about being long or being short (short selling) in the market.

The vast majority of investors invest in financial markets by buying a stock in the hope of later selling it at a higher price. When an investor buys a stock and owns it in the expectation of later selling it at a higher price, the investor is said to hold a long position; to be long the stock.

For markets to work efficiently there must also be a way for an investor to make a profit if they believe the price of a stock is going to fall. Assume a stock is selling for $30 per share. An investor believes the stock is going to fall to $20 per share. How can the investor profit if the stock moves lower?

Short Selling (or Selling Short) is when an investor sells a stock before buying (owning) it. With short selling, the investor reverses the typical order of buying a stock and then selling it. Instead, they first sell it and then buy it. How can this be accomplished?

To sell short, the investor borrows shares of stock from a brokerage firm and then immediately sells them. The important point is that the investor owes the brokerage firm the shares of stock that were borrowed (not an amount of money).

Assume an investor wants to sell short 100 shares of a stock with a current price of $30 per share. The investor borrows the 100 shares of stock from their brokerage firm and immediately sells the stock. The investor receives $3,000 (100 x $30) from the short sale. The stock eventually falls to $20 per share. The investor then buys back the 100 shares at $20 per share, costing the investor $2,000 (100 x $20). The investor pays back the brokerage firm the 100 shares they owe them, giving the investor a profit of $1,000.

By reversing the order of buying and selling (selling first and then buying) the investor is able to profit when a stock goes down in price. The key, again, is that the investor owes the brokerage firm the shares of stock that were borrowed (not an amount of money). Whatever it costs to buy the stock back after selling it is the cost to the investor. When an investor buys back stock after selling short, the investor is covering the short sale.

A short seller loses money if the price of the stock rises after making the short sale. In the example above, assume that instead of falling in price in the price of the stock rises to $40. The investor decides to buy back the stock at $40 per share. The cost of buying the stock back is $4,000 (100 x $40). The investor received $3,000 when they sold the stock so there is a loss of 1,000. The investor pays back the 100 shares to the brokerage firm.

In the case of GameStop, big hedge funds believed that the price of GameStop stock was going to go down. They sold short millions of shares at billions of dollars. Small investors (particularly customers of GameStop who wanted the company to succeed) used social media to encourage others to counter the hedge funds by buying the stock to support it price. Their efforts were successful, began to snowball, and the price of GameStop stock skyrocketed. The hedge funds, who had sold short, were confronted with billions of dollars in losses as the stock climbed ever higher. As they scrambled to “cover” their short positions by buying back the shares they owed, the price of the stock rose even higher multiplying their losses (this is called a short squeeze).

The ability of small investors, through social media, to thwart the efforts of big hedge funds and affect stock prices is a new phenomena. The government and financial markets are just beginning to grapple with it.

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