What Does Short Selling Mean? The Jargon-Free Answer

The recent meteoric rise (and fall) of GameStop stock captured the attention of the entire world.  There was something mystical about a bunch of awkward dudes wearing T-shirts and living in their parents’ basements irritating the hedge fund types.  But how, by driving up the price of the stock, did these misfits cause the Armani-wearing, Bentley-driving clan to lose a ton of money? The key concept to understand is short selling.  It’s a commonly used yet risky tactic that can generate large sums of cash (or do quite the opposite).  But what exactly does short selling mean? We’ll answer without using much jargon, mostly because we don’t understand it.

 

The Concept

When you buy shares of stock in a company, the hope is that the value of the shares will go up over time.  When you ultimately sell the shares, you pocket the difference between the price at which you sell and the price at which you bought.  Pretty simple.

With short selling, or shorting, you actually hope the value of the company’s stock goes down.  You borrow shares from a broker and sell them at current market value.  Obviously, you need to ultimately return those shares to the broker (along with interest).  The hope is that when you buy the shares to return to the broker, they are cheaper than the price at which you sold them.  You then keep the difference.

As an example, let’s say you take a short position on Company X.  You borrow one share and sell it for $50.  Later, when you buy the share to return to the broker, it only costs $30.  You have made $20 minus any interest owed to the broker.  Obviously, when done on scale, the numbers can get big pretty quickly.  Alternatively, if the price of the share were to unexpectedly rise to $500, you would lose $450 plus interest.  As such, losses can also add up quickly.  Furthermore, there is no cap on the losses.  In other words, if the share went to $2000, you would lose $1950 plus interest, an so on.

 

The Concept Applied to GameStop

When a community of amateur traders on the social media site Reddit caught wind of the fact that certain hedge funds had taken a short position on GameStop, some serious drama/entertainment ensued.  This community acted in concert to dramatically increase the value of GameStop shares, putting the short sellers in a very precarious situation.

How was the effort coordinated? Large numbers of small investors bought either shares of the company or options that anticipated a future rise in share value.  Depending on whom you ask, the large-scale purchase of such options can indirectly lead to a rise in share value.  At least temporarily, the crew agreed to hold on to their shares as opposed to sell them for significant gains, thus maintaining share price.

Short sellers found themselves obliged to buy shares to limit what were becoming bigger and bigger losses.  Such purchases in and of themselves drove up share value even further.  In essence, a snowball effect was in full force.  That is, until widespread selling began, sending the snowball in the opposite direction.

 

The Rest of the Story

The above story was, of course, not limited to a simple David and Goliath tale.  The massive purchasing activity stressed certain trading platforms, forcing these platforms to temporarily halt purchases, leading to a drop in share price, several conspiracy theories, and governmental investigation.

When GameStop shares soared to massive heights, a clear disconnect existed between share price and actual company performance, leading some to question the validity of markets in general.  In their eyes, emotion and gamesmanship have a disproportionate effect over hard financial data.

Finally, some of the little guys who were late to the game purchased shares at what turned out to be a high, making these small-time investors unfortunate victims themselves.

 

In the end analysis, the entire saga seemed to take many known imperfections in the system and accentuate all of them simultaneously.  For some, the spectacle meant big gains, and for others it meant huge losses.  For the rest of us, the result was some great theater.  But will this theater result in less short selling? Probably not.