Your Money: The Gamestop Saga Part 1 – Short Selling

Here at Plutigo.com we are not really in the business of talking about what’s going on in the stock market, and we certainly don’t provide investment advice. Instead, we focus on helping you make smart decisions about how to find the best value on financial products.

In this multi-part series we use an example from recent financial headlines to dig deeper into the philosophy behind what we do, and why we believe it’s important for our readers.

While of course it makes sense that we all want to be well informed so we can find good values on things that are important in our lives, like for example car insurance, it’s also interesting to dig into exactly why this is the case. In our estimation it’s because, whether we like it or not, our financial lives are an important part of our overall quality of life. And for that reason, we believe it’s important that we occasionally discuss financial topics that go beyond just reviews of car insurers, IRA providers, lenders, etc.

In fact, it’s crucial for all of us to have at least some awareness of the greater financial world, the implications of some of the unprecedented events that are taking place in it on a regular basis in these turbulent times, and their potential impact. It’s for this reason that we are moved to write about the dramatic, and for many people puzzling, “short squeeze” that took place recently, driving the price of Gamestop stock (NYSE: GME) to dizzying heights in just a few short days of trading.

Let’s be clear: we don’t think it’s particularly crucial for you to be an expert in the mechanics of short squeezes. Instead, the topic is merely an example of something that can have a major impact on your financial situation, and which you may not only know nothing about, but have ever even heard of. If you can be affected by a short squeeze, what else might there be that you don’t know about that could hurt (or even help) you?

Unfortunately, in our financial world today, the answer is “A LOT.” We are living in financial times in which ignorance is decidedly not bliss.

The Gamestop story – selling stock short

The story of what happened with Gamestop, and a few other companies such as AMC Theatres (NYSE: AMC) and Blackberry (NYSE: BB) that had similar trajectories for the same reason, can be laid out fairly simply.

Gamestop is a company with a business model that many business and financial experts believe is in a powerful decline and has a very dim future. It is a chain of bricks and mortar retail outlets selling video games. Gamestop was once very successful but now finds itself in an industry where most products are sold and used online. And its customers are decidedly internet savvy, given that they’re gamers who spend all their free time online, so there has been no hesitation for the customer base to abandon Gamestop and move to the new distribution channel.

Looking ahead 1 year, 3 years, 5 years, there are very few people who believe this trend is going to reverse, and a company with tremendous overhead costs like real estate, retail employees, etc., is going to make a comeback. In fact, most industry pundits predict that Gamestop will be bankrupt very soon as a result of having the wrong business model to thrive in the new paradigm, just as so many other bricks and mortar retailers have seen their businesses die in the face of e-commerce. It’s the story of Borders vs. Amazon, or Blockbuster vs. Netflix, and we know how those battles played out.

If one believes a company is doomed to extinction, that belief is typically accompanied by a belief that the price of its stock is going to fall, eventually becoming worth zero. This is the flipside of believing that a company is going to be very successful in the future, which would very likely correspond to its stock price increasing significantly over time. Most people are familiar with this second situation, where you might decide to buy a stock because you think it’s going to “take off,” increasing in price and allowing you to eventually sell at a significant profit. In other words, you “buy low and sell high,” as the old expression says.

Wouldn’t it be interesting if there were a mechanism to bet on the first situation, where you believe you have solid insight that indicates a stock is going to decline dramatically in price? You have done your analysis of the business situation, just as in the case where you believe a stock will increase in price, so why shouldn’t you be able to put your analysis to the test? In fact you can.

Traders who believe a stock will fall can bet on that outcome by “selling short,” which means that they reverse the order of the optimistic trader above by first selling high and then (hopefully) buying low later on.

They do this by first borrowing the stock, which they do not own, from someone else who does own it, and then immediately selling it. They are assisted in this by their broker, who has access to other customers who own the stock and is able to borrow it from them (for a fee.) Once the trader has succeeded in selling the stock short, he then waits and watches, hoping that his thesis for the decline in the stock plays out. If it does, then at some point he may decide to “cover the short position” by buying back the number of shares he has borrowed at that lower price and returning them to the person he borrowed them from.

It’s as simple as finding a stock selling for $100, deciding the price is destined to fall and thus borrowing, for example, 1,000 shares and selling them. You have borrowed $100,000 worth of stock. If the stock then falls to $20, you might decide you want to “cover your short” and take your profits, so you buy 1,000 shares, which now costs you only $20,000, and return the 1,000 shares to the person you borrowed them from (again, assisted by your broker.)

So you bought low and sold high, but you did it in reverse order by first selling high and later buying low. Your results are impressive, because you sold it for $100,000 and bought it for $20,000, meaning you made a profit of $80,000 (minus a few percent for the cost of borrowing the shares in the first place.) It’s exactly the same as if you identified a stock that was increasing and bought it for $20,000 and sold it later for $100,000.

Of course as Yogi Berra once said, it’s tough to make predictions…especially about the future. If it were as easy as the scenario we just presented, everyone would be fabulously wealthy from knowing how a stock will perform in the future and betting accordingly.

And therein lies the risk. If you short the stock at $100 and, for any reason at all, your prediction doesn’t come true right away, the stock price might rise. What happens if it rises a lot, like to $150 or $250? Well, you’re on the hook to return those 1,000 shares at some point by buying them back in the open market. But if the stock is now selling for $250 a share and you want to cover your short, you have to come up with $250,000 in cash to buy those shares and return them to the person you borrowed them from. Recalling that you only received $100,000 when you first sold them, it’s clear that you are $150,000 in the hole.

Importantly, the brokerage firm that helped you borrow the shares in the first place is watching the process unfold, and at a certain point it may not trust that you have enough cash to buy back 1,000 shares, so it will require you to put up a certain portion of the money as a “margin requirement.” This is known as a margin call. If you don’t have the money to put up, i.e., you can’t “meet your margin call,” you will be forced to cover your short immediately. In fact, the broker will actually do it for you, without giving you any choice in the matter, and you have to take your loss – even if you believe the stock price increase is only temporary and it will eventually go down below $100 and prove you right, allowing you ultimately to make your profit.

What is worse, if you really don’t have $150,000 to cover the loss you owe to the broker, you can be forced to declare bankruptcy. So you can see, there is a lot of risk in selling stock short, because you can lose a lot more than the initial amount you “invested” if your prediction is wrong. Unlike when you buy a stock, in which case the most you can lose is the amount you invested (if the stock were to go all the way to zero), , there is no limit to how much money you could lose on a short sale gone awry, because there is no limit to how high a stock price can go. In theory, even Bill Gates could go broke by shorting stock if the stock price goes up high enough.

Even if you are 100% convinced that your original thesis about why the stock price MUST go down is correct, you have to remember an old expression about the markets,

“The market can stay irrational a lot longer than you can stay solvent.”

This expression is also applied to casinos as well as markets. The casino and the market have deeper pockets than you, so you have to manage your risk carefully in the short run in order to survive long enough to benefit from an advantage you may have in the long run.

Now you have a general understanding of what it means to be a short-seller in the stock market. In the second edition of this 3-part series on Gamestop, we will explain how the theoretical risk of short-selling can turn very real, and potentially lethal, in what’s known as a short squeeze.