A step-by-step guide to short selling
- Irene the Investor thinks that the value of Company X’s stock is going to plummet.
- She borrows 100 shares of Company X’s stock from her broker, then sells them at their current value, or $50 per share.
- After a certain period of time, Irene has to return her shares to her broker. But now, she can buy the stock back at its current value, or $20 per share.
- She makes $30 per share in profit from Company X’s bad fortunes.
So what's the risk?
If, instead of falling, Company X’s stock climbs to $100 per share, Irene is on the hook for that $50 per share difference. Her broker won’t let her keep that stock indefinitely, especially if she doesn’t have the funds to cover her losses. Eventually, she’ll run out of time and will have to give her borrowed shares back at a massive loss—what investors call a “short squeeze.”
Tony Cookson, an associate professor in the Leeds School of Business, likes to reference a famous quote by the economist John Maynard Keynes: “The markets can remain irrational longer than you can remain solvent.”
The quote seems particularly relevant to the story of GameStop, a video game retailer that many analysts thought was destined to share the fate of Blockbuster.
Then in January, a group of everyday investors, many recruited through the online platform Reddit, seemed to have pulled off the ultimate “short squeeze”—temporarily catapulting the value of GameStop’s stock and causing major headaches for Wall Street hedge funds.
Cookson studies the behavior of investors. In 2020, for example, he and his colleagues reported that many day traders base their decisions on the feedback they get from internet “echo chambers”—losing money as a result. The saga of GameStop, he said, shows just how much the online world has fundamentally changed how the stock market works.
He sat down with CU Boulder Today to talk GameStop and why it may not be the David and Goliath story that many internet memes suggest.
From an investor behavior standpoint, what makes the GameStop situation so unusual?
One of the things that I teach in my investments classes is that if you’re an individual investor, once the information about a stock reaches you, don’t bother making bets on individual stocks. Even if you have read a news story about the company, you don’t have any information that the market doesn’t already have, and information is what typically moves prices.
In this case, the institutions, the sophisticated investors, had information that GameStop was priced too high, so some of them took short positions in the stock. Yet in the face of that, retail investors seem to have piled in, driving up the price, and made it so expensive that those sophisticated investors had to close out at huge losses.
This story has really struck a chord with people in a way that many news stories about the stock market don’t. Why?
The message we’ve seen in the media is that this is a case of the little guys versus Wall Street, which captures the imagination of people beyond finance. I don’t think it is that simple.
How so?
Tony Cookson
Some funds have had to close out in a losing position, but there are plenty of institutions, also sophisticated money, who piled in with these retail investors and went along for the ride. Given the information these institutions have, it’s pretty unlikely that institutions would see this situation and not act on it.
So it may be more of a case of Wall Street versus Wall Street?
Indeed. Based on the numbers I’ve seen, from buy and sell orders routed to Citadel Securities, retail investors were net sellers of GameStop on Tuesday, Wednesday and Thursday last week. GameStop reached its high of $483 per share on Thursday. After the initial jolt of interest by retail investors on Monday, it looks like GameStop reached new highs due to mostly institutional trades.
You’ve studied how investors are changing their behaviors, and losing money in many cases, based on internet “echo chambers.” Do you see connections to what’s happening with GameStop?
Yes. We study how people confirm their investment opinions by following other users with similar opinions on an investor social network called StockTwits. In our setting, we can see, for example, that some of these people are bullish on GameStop stock, and they’re not really seeing any information that goes against that opinion. Because they follow people like themselves, they’re going to hear information, spins on news about GameStop that are going to be more positive on average.
We study all sorts of stocks, not just GameStop, and we find in our paper that this sort of echo chamber associates pretty strongly with trading volume in the market, and we also find that this is costly for retail investors. Following the recommendations of people in your echo chamber is often a really good way to lose money.
The brokerage firm Robinhood has received a lot of criticism for restricting GameStop trading? Why are people are so upset with them?
I think people had the impression that Robinhood was protecting the institutions that were on the opposite side of this. However, as a brokerage, they have certain requirements they have to meet. It’s the nature of what they do that they can’t let all their investors pile into this one position because it exposes them to risks that regulators wouldn’t allow, without Robinhood posting significant sums of money as collateral.
How, if at all, might this affect the big traders moving forward?
This situation is driven home just how risky doing a short sale can be. These funds may be a little more cautious about taking a short position moving forward, especially with stock that is already heavily shorted.
What would you tell normal investors about how they should approach the current, volatile market?
If you’re a normal investor, you shouldn’t be dealing in daily trades. Day trading, or riding these bubbles, is gambling on other people’s emotions.
My recommendation for the normal, everyday investor is to stay diversified. Diversification keeps you from being exposed to the weird risks that can happen because of investors’ random ideas. You don’t want to subject yourself to those risks, especially if it’s your retirement savings
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GameStop may not be the David and Goliath story you think, researcher says - CU Boulder Today
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