A major stock market event occurred during the week of January 25, 2021. The current lore is that a group of humble retail investors put a serious hurt on the hedge fund experts who had shorted GameStop stock. As a result of the online amateurs banding together to drive up the stock price, the hedge funds lost billions of dollars.
I’m discussing it in today’s post because I found it both riveting and exceptionally educational. January 24, 2021 was the week that hedge funds bled billions of dollars because of a little thing called a short squeeze.
(In my humble opinion, the stock market events of January 2021 were far more enlightening than the predictable plunging of stock market values in February/March of 2020 due to the COVID-19 pandemic.)
At its most basic, this is how you short a stock:
Let’s say you ask to borrow your sister’s skirt. She says yes, but she needs it back in 4 weeks. You take the skirt and sell it to someone else for $100. Now, you have money in your hand but you owe your sister a skirt. You find a skirt identical to the one you borrowed, and it’s priced at $45 so you buy it. In 4 weeks, you’ve returned the skirt to your sister and you’re $55 richer.
Now, go back to the last paragraph and change the word “skirt” to “stock” and the word “sister/she” to “brokerage house”.
You now understand the rudimentary principles behind making money by shorting stocks.
Got it? Good. Let’s move on.
Why would anyone do this?
Why? You’re kidding me with that question, right?
They would short a stock for the same reason that they do anything in the stock market – to make money. To short a stock is to gamble that its price is going to decline between the time you borrow the stock to sell and the time you buy it back to return to the lender.
In the case of GameStop, the hedge funds borrowed the stock and sold it when it was around $10/share. They wanted the price to go down so that they could buy it back at a lower price. Once they’d bought it back at the lower price, they would have returned the stock to the lender and kept the monies earned. They would’ve had derived their profit from the difference between the sell price and the lower purchase price.
That was the plan anyway…
What is a short squeeze?
The short squeeze happens when the price of the stock (skirt) doesn’t go down. Instead it goes up. And since there is no limit to the stock’s price, the person holding the short can get squeezed pretty severely if the price doesn’t stop rising.
Remember, the stock (skirt) must be returned to the brokerage house (sister) in 4 weeks. So you might need to pay more than the original $100 to buy the same stock (skirt) from someone else.
During the week of January 25, 2021, very sophisticated hedge funds got caught in a short squeeze instigated by amateur investors who belonged to a sub-account on Reddit called WallStreetBets. The retail investors started buying stock in GameStop, thereby driving up demand for the stock. In-demand stocks have rising prices, which is exactly the outcome that the hedge funds did not want. Remember – in order for the hedge funds to make money on their short-bet, the price of GameStop stock had to keep going down.
After selling the borrowed stock for $10/share, the last thing the hedge funds wanted to do was to buy back the stock at $11 per share, $50 per share, or $400 per share. For every penny that the stock rose, they were losing buckets and buckets of money.
Don’t Try This At Home
Shorting stocks is not for amateurs. Yes, some of the retail investors in GameStop have made money. The ones who got in early, way back in 2019 when this started. The early investors would have bought at prices that were far lower than they are today. Those early birds would have profited handsomely this week if they sold at the GameStop stock price rose above $300/share.
Even the Ontario Teachers Pension Plan wisely took advantage of the opportunity to divest itself of its shares in the company which owned the malls where GameStop were located and earned $638 million dollars for its members.
Hedge fund managers who had invested in shorts when the stock price was less than $10 had essentially wagered that the stock price would go down further. The plan would have been to buy more stock at the new, lower price and keep the difference after returning the stock to the brokerage house.
This is not what happened.
By buying the stock, the amateurs drove the stock price up and way past $10. As more investors bought more stock, the price increased tremendously.*** The hedge funds still had to “cover their short”, which means they had to meet the deadline for the return of the stock they had borrowed and sold at the price of $10. In order to meet those deadlines, they had to buy stock at the much-higher price thereby losing billions in the process.
Absolutely fascinating to watch…
Shorting a stock is a risky stock market move. The risk lies in the fact that there is no limit to how high the price of the shorted stock can go. In other words, there is no way to accurately predict just how much money can be lost if the stock price doesn’t go down.
And as the events of late January demonstrated, even the experts can get financially walloped if things don’t go according to plan.
*** At the time of writing this post, the stock in question had hit a high of $469.42USD!