This article was originally produced as a video market update
Over the past quarter, there has been a great deal of discussion in the media with regards to dramatic price swings in the shares of companies like GameStop, Blackberry, AMC, and Bed Bath and Beyond.
This has left many people asking questions about short-selling, market manipulation and volatility as well as how and if this affects their Wealth Stewards portfolio.
What is short selling? Simply put, Short selling is when an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender. Short sellers are betting that the stock they sell will drop in price. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender. The difference between the sell price and the buy price is the profit.
In January 2021 short squeezes occurred on several different stocks, including GameStop and AMC entertainment holdings, Inc. following the efforts by retail traders on Reddit to drive up the price of these stocks. This resulted in large price swings as short sellers were forced to cover their short positions for substantial losses. These volatile price movements were not driven by fundamental factors or news about these companies.
Investors should be particularly cautious when considering trading stocks during short squeezes, short-selling occurs when an investor borrows a security and sells it on the open market planning to buy it back later for less money. Short sellers bet on and profit from a drop in a securities price. This can be contrasted with long investors who always want the price to go up.
Short selling has a high-risk high reward ratio. It can offer big profits, but losses can mount quickly and infinitely. For typical buyers of stocks, potential gain is unlimited, and losses are limited to the value of the purchase. For short sellers, potential is limited to only the value of the stock, but risk is unlimited.
A short squeeze happens when the price of the stock that is heavily shorted starts to rise and short sellers start to feel pressure as losses mount. This also triggers margin calls and forces short sellers to buy back their position, which in turn pushes the stock price even higher.
Let's take a closer look at GameStop. Since 2018 earnings of $4 a share shifted to a loss of over $10 a share as buying preferences for games changed from in-store to online purchases. Short sellers viewed this as an opportunity to sell the shares at current levels. With the view that prices would drop as the losses mounted.
Internet investors joined forces in January and targeted a few of these firms that were heavily shorted, forcing prices higher, which resulted in short sellers buying. This pushed the prices even further. At the beginning of 2021, there were 71.2 million shares shorted compared to 69.75 million shares outstanding. This means that virtually every share outstanding had been shorted.
Suddenly a large group of buyers driven by the organization of followers of websites like Reddit banded together and purchased large volumes of shares. Prices were pushed up, which put pressure on short sellers. Prices and trading volumes rocketed higher.
When you look at what has happened since the peak, you will see that prices plummeted from over $300 to $73 and continued to be volatile afterwards. If we broaden our view, we can see the same thing happened to Game Stop, Blackberry, AMC, and Bed Bath and Beyond. These stocks rose in price sharply in a very short period of time only to move to much lower levels. Although this seems like a get rich quick strategy, it all comes down to your trust in a stock promoter. If you got in early and sold at the peak, (which we can only know with the benefit of hindsight) you did really well, however those who got in late suffered large losses.
One of the core themes of this story was the “David and Goliath” element with retail investors triumphing against larger hedge funds. Short sellers have been depicted very negatively as people who take advantage of the average investor. Some do fall into this category, but many can also provide the average investor with lower risk strategies as they use shorting to offset the portfolio risk.
At Wealth Stewards, we do not short stocks. We help people to invest wisely in large companies with strong balance sheets and earnings growth. We do not invest in companies that lack the fundamentals or are on the verge of bankruptcy. There is always a concern that this type of trading weakens investor confidence and can have negative short-term impacts on the prices of great companies, but these things happen in the markets. It's more important to keep an eye on your strategy and to not let this type of news disrupt your long-term plan.
All examples are for illustrative purposes only and are not intended to provide individual financial, investment, tax, legal or accounting advice. This material is for general information and is subject to change without notice. Every effort has been made to compile this material from a reliable source. However, we cannot guarantee that information will be accurate, complete and current at all times. Before acting on any of the above, please make sure to see a financial professional for advice based on your personal circumstances.