By Rebecca Ellis
FRI 29 JAN, 2021-theGBJournal- Most of the time, commenting on the financial market is a dry affair about interest rates, economic statistics, and market movements. At times, though, some arcane corner of the financial the system comes to life and turns out to be quite entertaining – for those that are not directly involved or happen to be on the right side of the trade – where the word ‘right’ is open to debate as you will see.
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The amazing story today is about GameStop Corp., a retailer running video-game stores in malls during a pandemic. There is nothing particularly exciting about the business and it has been in decline for years. An activist shareholder built a stake in the company and wants to turn the business entirely digital – and value it like an ecommerce company instead of a staid retailer. Many remain skeptic.
After a swift appreciation last year, the GameStop stock attracted the attention of short-sellers. Short-selling involves borrowing a stock from say an insurance or investment or pension fund and then selling it. If the stock price goes down, the short- seller can pocket a permanent profit by buying the stock back for a lower price and giving it back to the owner. If the stock price goes up, the potential losses are infinite. The short sellers believe that the stock is overvalued and should trade at much lower prices.
Shorting stocks plays a critical role in maintaining market hygiene. Short positions can be part of risk management, and they are tools in portfolio management, by pairing under- and over-valued stocks and betting on the difference to narrow. The possibility of short-selling also helps keep the market honest by giving some investors an incentive to find companies that are too expensive and bringing their share prices down. Short sellers can often be essential to revealing fraud, remember the Wirecard story.
Most of the time short-sellers do not reveal their positions. Sometimes, however, word gets out and this now led to a coordinated “short squeeze” in which followers of a forum on Reddit banded together to buy the stock thereby driving up the stock price and inflicting ever more pain on the shorts — to the tune of some USD 6 billion of losses. Staggering.
If you are a retail day trader equipped with free trading platforms, spare cash, and boredom, looking to gamble on a stock, you do not need to buy the stock, you can buy call options to get leveraged exposure to the stock. Options are great if you have a relatively small amount of money and want to take a lot of risk with it. Meanwhile the market maker i.e. the bank or broker who sold you the options would have hedged its option exposure by buying shares of GameStop stock. More importantly, as the stock goes up, the market maker will adjust its hedge by buying more stock which, of course, pushes the price up more.
GameStop is an extreme example. More shares were shorted than are in circulation to the tune of 160%. Share prices rose 354% in the last two weeks, reaching an intraday 14-day gain of 612% on Monday, January 25. Trading volumes also soared during this period. GameStop’s stock typically sees about 7 million shares changing hands on an average day. Last Friday, the volume skyrocketed all the way to 197 million shares.
Some schadenfreude is inevitable when short sellers get into trouble. Here it is misplaced as they are in trouble to a quite alarming extent. Melvin Capital, one of the short-selling hedge funds had to accept an unprecedented injection of USD 2.75 billion from its rivals Citadel and Point72 Asset Management.
So far, we notice isolated cases of this trend. This phenomenon is unlikely to bring the house down. It may be tripping up sophisticated hedge funds that take pride in their superior skills at navigating markets but who would be first to tell you that it is a jungle out there. Indeed, it is. We take solace in our fundamental analysis of the stocks we buy and have stayed away from GameStop. For additional fun and excitement, we dabble in the long and short positions on shares of companies that we have researched, understand, and believe in. That should help us stay away from disasters in the making such as GameStop and others.