These retail investors use the online community forum to discuss stocks
they buy and sell. In early January, the discussion began to focus on
GameStop, which was a popular retailer for many young adults who
grew up purchasing their games and video equipment at local stores.
However, most people these days purchase their games from online
resources, which they can download and begin using immediately
without having to leave home. This has hurt GameStop revenues in
recent years, so its stock price basically plateaued and has remained in
the $4 to $20 range, with little upside potential. What got the attention
of these Reddit forum members, however, was that a large percentage
of the company’s shares were “short” positions.
2
How “Shorting” Works
Most investors make money by purchasing shares at one price and then
selling them at a higher price. Shorting is designed to do exactly the
opposite.
To short a stock, an investor borrows shares of that stock “on margin.”
This means he puts a fraction of the current value of those shares (e.g.,
10%) into a brokerage margin account, and the rest of the value is
basically considered a loan from the broker. During the period in which
the investor buys on margin, he pays interest on the outstanding loan.
Shorting is buying a stock the investor believes will drop in price. First,
he borrows shares from a brokerage and then immediately sells them
for cash. However, he can delay having to return the shares or repay the
brokerage until later. If the stock price falls, as expected, the investor
then buys back his position at the lower price and returns the shares to
the brokerage. He pockets the extra money he made between selling
them at one price and buying them back at a lower price. For example:
• Sell 100 shares of borrowed stock at $8 per share (prot: $800)
• Buy back 100 shares when the price drops to $5 per share (cost: $500)
• Return 100 shares to the brokerage and pocket the $300 prot
However, this strategy can be risky. Should the stock’s price increase
rather than decrease, the investor may have to buy back those shares at
a higher price in order to return them to the lender — in which case he’d
take a loss on the deal.
• Sell 100 shares of borrowed stock at $8 per share (prot: $800)
• Buy back 100 shares after the price rises to $10 per share (cost: $1,000)
• Return 100 shares to the brokerage and take a loss of $200
The investor can wait to see if the price will drop again, but the problem
is that as the value of those shares increases, the borrower may have to
add more money to his margin account to cover the increased value.
Also, he incurs the risk of the share price rising even higher, which means
he could lose even more money.