Short Selling and GameStop

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The times they are a changing…

As of Feb 1, 2021, the price of MSFT stock was $232 per share, with a market cap of $1.79 trillion. Which tells us that there are about 7.72 billion shares of MSFT stock in circulation. The average trading volume was 7.87 million shares, from which one can estimate that on any given day 99% of MSFT stock is being passively held, while about only 1% is actively traded.

Meaning that every trading day the one percenter’s set the price for the rest…

But this is true for just about any other financial asset, whether it be stocks, bonds, real estate gold or bitcoin, that most of the assets sit quietly on the sideline, while a small percentage establishes the price for all.

Is this a problem?

What if many MSFT shareholders, representing 0.5% of outstanding shares, representing $8.95 billion dollars of stock, all decide to sell their shares at the same time? A 50% boost in trading volume, all sell market orders? The stock price would plummet. But given the vast number of MSFT shareholders, and assuming that their actions are independent of each other, the probability of such an event is tiny.

Instead consider the case of GameStop, which has in comparison just about 70M outstanding shares, or about 1/100 of MSFT. Prior the recent GameStop stock price run-up, when the share price was about $10, it had a $700M market cap. While it is extremely improbably that a 0.5% boost in trading volume of MSFT will happen on any given day, can the same be said for GameStop?

At $10/share, 0.5% of the outstanding GameStop shares then represented $3.5M. Not a small number, but not terribly large either. As long as they acted independently, unlikely that shareholders representing 0.5% of outstanding shares would all buy or sell at the same time. But what if the actions of the shareholders are not independent, that they use social media to plan and organize, to collectively purchase (or sell) $3.5M worth of stock at about the same time?

Not only do we now know that such as event is possible, we also now know that it will certainly cause a spike in the price of the stock.

But why GameStop? Because there is more to the story, there is a reason its stock was the target of a focused group buy.

In general, if one believes that the price of a given stock is going to increase, then the logical actions are to:

- Hold the stock you already own (linear ROI)

- Buy more of the stock (enhanced ROI).

Note that by doing so, you have to a small degree contributed to a self-fulfilling prophecy, that your individual actions have provided some additional demand for the stock, provided some upward pressure on the price, the amount depending on the size of your purchase.

What if one believes that the price is going to decrease? One logical action is to sell whatever stock you own. You will not make any money, but will not lose either. But is there more that you can do?

Sure. Recall that 99% of a typical stock is just passively sitting somewhere. What if you were to borrow some of that otherwise passive stock, agree to an interest payment and agree to return the shares whenever the lender asks for them back? A deal is struck, the borrowed shares are in your position, and you immediately sell them.

Which once again is a stock “self-fulfilling prophecy”, as your action of selling these shares applies some downward pressure on the price.

With any luck, the shares drop in price, allowing you to re-buy the shares at the lower price (an upward pressure on the price), and return them to the original owners. Hopefully for you netting a nice profit, the difference between the sale and repurchase price.

This is known as “shorting stock”.

If things go south with a stock purchase, the most you can lose is your investment, but with a stock short, depending on how high the stock is when you are forced to buy, the loss can be many times your possible gain.

Back to GameStop. It is now well known that a certain hedge fund had taken out large short positions on the stock, applying downward pressure on the price. Perhaps many others believed that the business was failing, selling their stock. For whatever reasons, from Jan 2016 to April 2020, the stock price gradually dropped from $30 to $2.80.

All the hedge fund had to do was to re-buy the shares at the lower price and return them. But for whatever reason they did or could not, and the price started increasing, reaching about $18 on Jan 8, 2020.

And then social networked stock buyers struck, quickly pushing up the price, reaching $347 per share on Jan 27. It will be assumed that the leaders of this organized buy effort bought into GameStop before the price increase…

Recall that the lenders of the shorted stock can ask for them back whenever they want, and you should assume that the higher the price went, the louder they asked, forcing the short sellers to buy the stock at the now higher price, adding demand fuel to the fire, pushing up the share price even more.

And the rest is history, with the hedge fund, Melvin Capital, transferring about $6B of its wealth to shareholders of GameStop in January, 2021.

It should be noted that the company Gamestop does not directly benefit from this assumed to be temporary inflated share price. But it is certainly preferable to the share price being pushed down to zero.

Who knows what happens next? No doubt more short positions have been taken out on GameStop stock, and no doubt, the social organized asset buyers will strike again, perhaps GameStop, perhaps another heavily shorted stock.

What have we learned?

- The genie is out of the bottle, RobinHood and Reddit are not going away.

- Short selling is risky.

- Social media combined with brokerage trading for the many has enabled the mass focused buying and selling of financial assets.

- Making short selling both risky and perhaps even stupid. Might as well paint a target on your financial back.

- That given that we depend on market price stability, perhaps we should rethink the overall economic benefit of risky betting on financial assets, especially the short selling of stock.

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