When a stock that was trading at $40 last week suddenly hits a price of $500, people—even people who don’t pay attention to the stock market—begin to sit up and take notice.
For about two years of my journalism career, I covered the microcap stock market – a place where you can buy 100 shares for a dollar, and sometimes you get lucky, and the price jumps up, and suddenly you have 100 shares worth two dollars. Or (if you’re very, very lucky and smart and do an extreme amount of due diligence) you can suddenly have 100 shares worth $10,000.
Because of that background, I’ve been getting many questions about what exactly went down yesterday with Grapevine-based GameStop. For everyone who managed to escape somehow the steady flurry of posts about the company’s meteoric stock price jump, a quick catch-up: Since last week, Reddit users have been buying up shares of GameStop, all because many on Wall Street think the company will fail. So far, they’ve been able to push the stock price up by about 10,000 percent. The effort from the stock trading Reddit community at r/WallStreetBets aimed to create demand for the stock and force a rally.
Now, why does this hurt? Well, for the average person with no skin in the game, it’s just mostly entertaining. But if you’re a hedge fund with a short position on GameStop, you’re sweating.
Shorting is (in the simplest terms) where you borrow stock from your broker, sell that stock at whatever it’s currently trading for, then wait for it to drop. If it does, you repurchase it at that lower price, give the broker their shares back, and pocket the difference as profit. If you borrow 10 shares of Widget Co. stock from your broker when it’s trading at $8 and then sell it for that, then repurchase it when it hits $5 a share, you have made a profit of $3 per share.
The act in and of itself is legal. What is illegal is if you have information about the company that the public is not privy to, that helps you determine which companies you want to have short positions in. That would be insider trading.
In the case of a hedge fund with a short position in GameStop, the stock’s increased price resulted in what is called a short squeeze – meaning they are now upside down in their position and will have to consider buying for a loss to replace the shares they borrowed.
There are a few other terms you might see tossed around, too, in the discussions around shorting.
Naked short selling, for instance, is illegal (although there are so many loopholes). Naked short selling is when you short stock that doesn’t exist (or can’t be proven to exist). If you borrow and sell 10 shares of Widget Co. stock, but there are only 5 shares of Widget Co stock available for purchase (“the float” – or how many shares are out there to be purchased), you are naked short selling.
Another term you might see is “pump and dump.” While shorting and naked shorting doesn’t always involve this, it often does. Pump and dump practitioners will manufacture “good” news (usually untrue) and publicize it aggressively to make a company’s stock price artificially inflate so they can then sell their shares at an artificially high price, having bought them at a bargain. This stock manipulation is illegal.
Shorters will often (if they’re savvy enough) recognize pump and dump activity and “borrow” the stock when it is higher and sell it, knowing that when the pump and dumpers “dump” their shares, the price will fall again, they can repurchase at a lower price, and pocket the difference. The savviest will be able to time their borrow and sale for when the shares have reached the apex of the pump, just before the sell-off (or dump) begins.
However, in the case of the Reddit community that caused the GameStop rally, it was good old fashioned crowdsourcing, good eyes, and timing that seem to be the drivers—all of which are completely legal.
WallStreetBets—the community has nearly 4 million members—realized that GameStop was being aggressively shorted and saw an opportunity to thwart the effort by creating artificial demand by buying up shares, forcing shorters to pay instead of profit.
Estimates have the shorters losing at least $3 billion because of the effort, with about $1.6 billion happening Friday.
However, the effort may be a bit short-lived – at least in terms of GameStop. Brokers began restricting trade on the stock and then halted it this morning. The WallStreetBets community is still at work through aiming their sights on Blackberry, AMC, and Fort Worth-based American Airlines next.