"The investor’s chief problem – and even his worst enemy – is likely to be himself."
The GameStop "Short Squeeze" Drama
With many headlines dominated with GameStop, I thought it would be appropriate to give a simple, quick breakdown as to what's happening there, and explain a little more around what a "short squeeze" actually is. What's happening is actually fairly common as shorting stocks is nothing new, this just happens to be on a much larger scale and you're hearing more about it given who's participating, and how it all began.First off, what does it mean to short a stock? Shorting a stock, is when shares are borrowed, on margin (margin is essentially a loan), from someone who owns the shares. From there, you then sell those borrowed shares. When the stock declines in price, you who sold short, buy the shares back at a lower price, make a profit, and then return the stock to the person you borrowed it from. What's the risk of this strategy? Well, it's essentially unlimited risk. The stock could rise substantially, which means anyone that has sold short that stock, loses indefinitely until they buy back the shares to cover...which they'd be doing at a higher price in this case! It's no doubt, a very risky strategy.
This is exactly what's happening with GameStop, AMC, Bed Bath & Beyond and several other companies stock, albeit on a very large scale. This all started with a fairly prominent Hedge Fund broadcasting that they were taking a large short position (or selling short) the stock of GameStop - they were hoping the price would decline to make a profit. GameStop is essentially the RadioShack of Gaming - not really a prominent company anymore. Well, it turns out there was a large number of people on the Reddit platform that took offense to this, and all teamed up to buy the stock in a coordinated effort - and this effort has grown in scale over the last few weeks and days. We know that when there is buying demand for a stock, the price goes up. They wanted to push the stock higher, which would then cause losses to this Hedge Fund, and anyone else who was short the stock. When this happened, this then causes what's known as a "short squeeze." All these buyers pushed the stock higher, which caused losses to short sellers, meaning they needed to buy back the borrowed shares to prevent even further losses. With all the short sellers buying back their shares as the same time, there becomes even more massive buying demand, which pushes shares up even more! This is how gains of 400+ percent have happened in a number of days. And these companies, in no way, are valued properly at these prices! All of this is pure speculation and risk.
This has led to fears around a bubble in these stocks - for good reason. Fundamentally, there is no reason why these companies should be valued at current prices. The risk now, is a sudden drop in share price as people exit and sell their positions - which we're seeing today. I, in no way, suggest this practice as proper investing. People aren't buying these companies because they believe in their long term fundamentals. Let's call it what it is; it's gambling. The risk is massive, and this clearly could end very badly for people, some of which are purely chasing this action without a good understanding of what's really happening and are in it for the chance to "get rich quick."
Hopefully this is a helpful explanation around what's been taking place. Let me know if you have any questions or comments on this, or anything else, as i'm always here to help!
Ryan Mohr, CFP®
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