What a crazy week Wall Street had. If you followed the news, you must have heard of GameStop, a short sale, a short squeeze, and other fun stuff. Many people made millions, a few lost billions, plenty of them got angry, while some were satisfied. What just happened? Let’s explain few things first.
What is a short sale?
It’s very simple. You, the short-seller, borrow a share from your brokerage firm and sell it. You hope and wait for the price to go down. When it does you buy that same share again at a lower price and return it. You keep the profit – the difference between what you get when you sell and you end up paying for that stock.
Example: You are borrowing 100 shares of a company X from, let’s say Schwab for $10 each. You do not own the stock, meaning at some point you must return it to the original owner. But, you can sell the shares. You go ahead and do that. Now, you have $1000 in your pocket. There are three possible scenarios of what can happen to the stock price:
- The boring one, it stays the same. You don’t do anything.
- The fun one, it goes down to $5. You buy back those 100 shares for $500. Return them, and keep the $500 profit.
- The not so fun one, the price goes up to $15. (Or $25. Or…hm…$150? Theoretically, it has unlimited upside potential.) Now, you have to act fast and repurchase them as soon as possible to prevent a bigger loss if the price keeps increasing. So, if you buy them at $15, you spend $1500. Total loss $500.
Short selling is a risky business but can be extremely profitable. Not for everyone’s stomach. Essentially, you are betting against the company’s success. When the company fails, you, as an investor, succeed. When it doesn’t…
Well, then it comes “short squeeze”
Prepare the popcorn, the fun begins here. Of course, only if you don’t have to short sell.
Imagine that you have a lot of short-sellers who borrowed shares of the same company X. Remember, all of them are waiting for the price to go down. However, there is some excellent news coming from the company (they developed a new vaccine, perhaps?) that causes the stock to rise, fast. Investors are naturally attracted to the company, start investing in it, and the price goes up. All these short-sellers are now being forced to jump in and buy quickly shares that they previously sold to exit the trade and cut their losses. That’s called covering. It’s like the rat race. Because the number of short-sellers is high, the money that’s being thrown at the stock keeps pushing the price up even more. Economics 101: supply and demand. The losses for short-sellers are getting bigger and bigger. Panic kicks in, the prices of the underlying stock continue to rise, the short-sellers are out of luck. And lots of money.
That’s what happened this week on Wall Street. Big hedge funds were betting against GameStop, a video game store, among other companies, expecting the stock price to plummet. But, small, retail investors, who connected on a Reddit forum called Wall Street Bets decided to put their money to work buying shares of this company left and right, thus pushing the price up. And up. And up. About 1700% up. Yeap. According to New York Times, $24 billion worth of the company’s shares changed hands, the most actively traded stock on Wall Street. Those big Wall Street boys from hedge funds had to cover their losses. Gigantic losses, like $5 billion.
Brokerage firms had to protect themselves as well
Other companies that have seen an enormous gain in stock price are AMC, Naked Brand, Bed Bath & Beyond, Koss and Nokia. Since all of this was happening so fast, like in the past two days, on Thursday brokerage firms were forced to put restrictions on the trading of these stocks.
Robinhood, a popular investing app among millennials, explained: “Amid this week’s extraordinary circumstances in the market, we made a tough decision today to temporarily limit buying for certain securities. As a brokerage firm, we have many financial requirements. These requirements exist to protect investors and the markets and we take our responsibilities to comply with them seriously, including through the measures we have taken today.”
That did not sit well with the mentioned small investors. They shared their anger across social media. Apparently, they were so mad that they also bombed Google Play Store and Apple’s App Store with negative reviews of the Robinhood app, bringing it down to a 1 star. Google had to react by actively removing all these bad reviews, eventually recovering the app’s rating back to 4. Crazy, isn’t it?
That’s not all
One day, this is going to become a great blockbuster. Even the White House had to get involved. According to CNBC Jen Psaki, White House press secretary, said Wednesday that President Joe Biden’s economic team, including Treasury Secretary Janet Yellen, is monitoring the GameStop situation.
Lawmakers from both parties joined the game. Representative Alexandria Ocasio-Cortez (D-N.Y.) was loud and clear saying that Robinhood’s decision to restrict trading highly volatile stocks needs to be investigated. Sen. Ted Cruz, Republican from Texas fully agrees.
Sen. Elizabeth Warren, D-Mass, who has been advocating tougher Wall Street regulations for years is calling for the SEC to wake up and do their job. She twitted: “For years, the same hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades have treated the stock market like their own personal casino while everyone else pays the price.”
No one can predict what happens next. The market is very volatile, and it will probably stay that way for some time. If you decide to add some skin to the game yourself, be careful. Limit your losses, and don’t risk the money that you can’t afford to lose.
If you get lucky and make some crazy profit, don’t forget that what’s happening at the moment is an anomaly in the market. It may not repeat again anytime soon. But, I might be wrong. After all, Reddit investors demonstrated that it doesn’t’ take much to organize and financially hurt big boys.
Stay tuned, I know I will.