What happened to cause this massive (albeit temporary) increase in the value of the company? Did they develop a ground-breaking product that has changed the market? Have their sales and profits grown significantly? Have they expanded into new markets? The answer to all of these questions is “no”.
What has happened in known as a “short squeeze”, an attempt by a group of traders to push the stock price up to drive out short sellers. Short sellers buck the normal practice of investing in companies, expecting that the stock price will increase. Short sellers borrow a stock, then sell it, hoping to buy it back at a lower price (cover) and make a profit. They are investing, expecting that the stock price will go down. Hedge funds are some of the largest short sellers in the marketplace.
Some believe that short selling is wrong. Its un-patriotic. Its hoping someone fails so someone else can make a profit. However, short sellers do play an important part in maintaining stock market liquidity.
Short selling comes with significant risk as there is no limit to the amount one can lose on a particular trade. When you buy a stock the regular way (called buying long) the most you can lose is what you pay for the stock. If you buy 100 shares at five dollars, the most you can lose is $500.
Not so when selling short. A short seller would borrow and sell the 100 shares at five dollars, hoping the price drops to one dollar per share, whereas he would buy back the stock, pay back the lender and earn a profit of $400. However, if the stock price increases to $10 or $15 or $20 per share, the short seller would be buying the stock back at a price higher than he sold. If the stock price increases like GameStop did, the short seller can be wiped out, which is what happened to a number of hedge funds that heavily shorted the stock.
The stock price increase of GameStop was driven by a group of traders on social media, who hyped the stock, driving its price up to astronomical levels. As the stock price increased, the original buyers sold out to subsequent buyers, earning enormous profits and driving out the short sellers who had to cover at a price higher than what they sold. Also the last buyers in are left holding the bag when there are no more additional buyers. That is when the stock price drops as it has in the past week or so and those last buyers also suffer significant loses.
We do not recommend short selling to our clients. The prospect of unlimited losses does not make for prudent investing. We still believe in a strategy of steady, well-diversified portfolios that will stand the test of time. The constant theme in most of these writings is to follow a well-developed plan to help achieve your financial goals.
James J. Denora, CPA, CFP®