If youre new to high finance, then the concept of shorting is bizarre and convoluted. People actually make money from stocks falling? How is this possible? Why is it legal? Does this contribute anything to society? Am I missing out? Heres how shorting works.
Lets say you have a neighbor who is a cat lady that collects Beanie Babies. She has one prized beanie called Roary the Lion, worth $5000 (according to the intellectual darkweb, where these things are traded). Unfortunately, shes got some bills coming due this month and she doesnt want to be forced to sell Roary. So you offer to borrow Roary from her for 3 months in exchange for $200. Shes happy, because shell get her doll back in a few months and she now has enough money to cover her bills. The second you walk home with the beanie, you go online and sell it to the highest bidder. You manage to get the asking price, $5000. Now fast forward 3 months. Suddenly Beanie Babies arent worth as much as they used to be. You see a mint condition Roary the Lion for sale at only $100. You buy it, and give it to your neighbor. Done deal. Its not the same doll your neighbor loaned you, but she cant tell the difference. So during this whole process, youve only shelled out $300 and youve made $5000, for a total profit of $4700. Your neighbor would have lost the value of Roary anyway because of the market crash, but at least she got to use that $200 to pay her bills. This is shorting.
In the world of stocks, shorting is fairly common. You can find daily updates on the most shorted stocks, and see that hedge funds and individual traders are regularly making and losing millions of dollars by finding distressed or scammy businesses and shorting them. Occasionally short sellers will provide the markets with a valuable service they will hire private investigators to go spy on businesses to make sure they are telling the truth about their operations. Sometimes the investigators will uncover major fraud, so the hedge fund will heavily short the company sending a signal to other market participants: Hey, check this out. Its overvalued. This is what some shorts attempted to do with Tesla. They flew drones over Teslas factories and storage lots, and reported that Elon Musk was hiding a bunch of unsold vehicles. This wasnt exactly true, but the Elon- haters wanted it to be true, so they went with it. Tesla became one of the most shorted stocks of all time, forcing the price lower and causing Elon major headaches on top of his struggles with Twitter and the SEC. But the Tesla diehards believed in the company and trusted that demand for the vehicles would materialize eventually. When Tesla unexpectedly posted a quarterly profit, everything changed. The stock rocketed higher.
This brings us to another aspect of shorting that is a bit more interesting (and explains why its so dangerous). Lets say you borrowed a bunch of Tesla shares at $400 and immediately sold them because you expected the price to fall soon. But instead of falling, the price starts to climb. You are contractually obligated to buy these shares back before a set date, so you are sweating bullets. The higher the price goes, the less sleep you get. The only way for you to cut your losses is to buy the shares back immediately. But if youre stubborn, you wont do this. Surely the market will realize Tesla are liars, right? Theres no way electric cars are really that popular. If you went long Tesla (just buying and holding shares), your potential losses are limited to what you invested. So theres a cap. But when you short, you could lose far more than 100%. Remember that you only paid a small fee to borrow the shares, you didnt actually buy them. To close your short position, you have to buy the shares back, and that adds to the existing demand for the stock, which drives its price even higher. Its like an insidious trap that clamps down harder on your foot the more you struggle. This is called a short squeeze. It can create a cascading effect where one unfortunate short buys back shares, forcing the price higher, which destroys another short above him, forcing the price even higher, destroying another short above him, and so on.
Thats what happened with GameStop. A ragtag group of Reddit daytraders called /r/WallStreetBets found an illiquid stock and noticed it was loaded up to the rafters with Minecraft TNT (shorts). So they set it on fire. It didnt require a lot of money to make this happen, because GameStop is a small company and its market was thin. The price immediately shot up, forcing shorts to buy. The hedge fund Melvin Capital was in the eye of the hurricane because they bet billions on GameStops demise. The final amount of losses is not yet known, but it may exceed ten billion dollars, which could put Melvins Jewish founder Gabriel Plotkin out of business.
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