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GreenStar Newsletter Excerpt: Shorting Stocks from February 2021

GreenStar Newsletter Excerpt: Shorting Stocks from February 2021

A few times a year, something from the stock market hits the front page news. We may hear terms that we haven’t heard before or perhaps never fully understood. These are great educational opportunities; even if the events are unrelated to your GreenStar portfolios.

We are always hesitant to say something new has happened, but this past week something did. Before we go into that, we have to explain what “shorting a stock” means.

Loosing Your Shorts

A “short” is when you borrow a stock from a broker and sell it immediately at its current price. When you do this, your hope is that the price falls, so that when you buy the stock back later to return the shares to the broker, you make money off the difference. Yes, this is weird, but it has been around a long time.

Let’s say that I want to short XYZ Company which has a current price of $100. I borrow one share from the broker and sell it immediately on the market for $100 … but I still owe the broker that one share of stock that I borrowed. This means I’ll need to eventually buy a share no matter what the price is. This is called “covering” your short position.

Let’s imagine that after I short XYZ Company, the price drops down to $48. I decided to cover my short position by buying the one share of stock at the current price and giving the share back to the broker. Thankfully, I still have that $100 when I sold the one share that I borrowed. I can take that $100, buy the share at the current price of $48 and keep the $52. Here’s an animation of what this would look like when you short a falling stock:

Not too shabby, but easier said than done. However, let’s say that instead of going down, the price rises up to $142. Yikes. I still need to return the borrowed share. This means I have to go buy the stock at the higher price. I can use that $100, but I’ll need to look under my couch cushions for the additional $42. This is obviously a loss to me.

Another thing to point out is that when I close my short position, I am actually buying the stock to return it to the broker. This action of buying has the effect of pushing the price higher. On the other hand, when you short a stock, it pushes the price lower because you are borrowing shares and selling them right away. This will be important later.

We can imagine a more extreme scenario where the price is really volatile. Perhaps the price goes down at first and we are in a good position, but then it suddenly charges up to $586 before I decide to cover my short position. I would only have $100 in my pocket and have to come up with another $486 to close out the position. Yes, this means I lost way more than the price of the stock when I first took my short position. We could visualize this horrific path:

You can imagine a scenario with a runaway price where losses could be very high. Theoretically, they could be infinite.

This creates strange market dynamics. When you own a stock the normal way, it’s possible the price could go to zero and you lose at most all the money you invested. However, in normal circumstances with a healthy stock, investors have the option to patiently wait for a price recovery. Short sellers are not in this position. If the price is charging upwards, their losses can go on forever.

Get Shorty

ENTER: GameStop. Yes, this is the same retail store that you see in strip malls. They sell video games, primarily in brick and mortar stores – a company well past its prime, that is losing money and has had a bad five-year run.

Logic would have it that, GameStop was following the well-trod path of a declining retail store. Smelling blood in the waters, several large hedge funds took short positions in GameStop which pushed the price downward. As the price went down, more short-sellers piled on and pushed the stock further.

However, that’s when something new happened. Some people on Reddit saw what was going on and convinced a large group of small investors to join forces and buy as much GameStop stock as possible. This had a reverse siphon effect where it made the stock price rise and forced the hedge funds to cover their shorts … forcing them to buy shares of the stock … this buying demand made the stock price rise further … which made more short-sellers cut their loses … forcing them to buy shares of the stock. To add to this, other people saw the stock rise and bought shares to jump in on an inflating bubble.

Losses at US firms have topped 70 b-b-billion dollars. Some funds had to completely close down after experiencing 100% loss. This is called a “short squeeze.”

Who Wants Short Shorts?

A few of you have asked what we thought of this. We think it’s possibly illegal … and a little bit hilarious. On the comedy front: A Reddit forum beat giant hedge funds at their own game over a game store with waning relevancy. It’s like Revenge of the Nerds and Mr. Smith Goes to Washington all in one. On the legal front, while we are not lawyers, our read of securities law suggests that the folks on Reddit who partook in this may have engaged in market manipulation (ref. Section 9(a)(2) of the Securities Exchange Act of 1934). It’s a bit opaque at this point.

About shorting in general, it’s not going away. We think that the best solution is increased transparency. If short positions are easier to see, investors and funds will be at a higher risk of this happening, and less eager to take those positions.

On the other hand, it’s worth discussing whether shorting should be limited. We live in a world where:

-You can’t sell houses you don’t own

-You can’t sell cars you don’t own

-But you can sell stocks you don’t own

Stock shorting is a relic from the horse and buggy days. We can imagine somebody in New York who wants to sell stock that he or she owns, but those physical stock certificates are in Chicago. Instead of saddling up your horse to get them, people would borrow the shares so that they could sell them today. Later they would have to deliver their shares from Chicago to the broker they borrowed from. It was a mechanism to accommodate a different world. Now it’s more common that people have “naked shorts” – which in this scenario means that there aren’t shares back in Chicago.

It’s hard to see how the mechanism of shorting is adding much value today. Indeed there are some instances where it’s very important to be able to lock in the price of a security (particularly commodities) as a type of insurance. One could say that, by analogy, there are some who have an “insurable need.” But that’s not what this was about.