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Short selling? Short squeeze? GameStop? What? A beginner’s guide to the most chaotic business news story of 2021

January 28, 2021, 11:23 PM UTC

It’s been the biggest story in the wide world of business this week: GameStop’s incredible, crowd-fueled stock rally, which saw the video game retailer’s share price climb from around $19 at the start of January to nearly $350 at the close of trading Wednesday—an extraordinary 1,700% gain.

How could a company with such an unspectacular balance sheet (it has posted a net loss of $275 million over the last 12 months) and an seemingly outdated, brick-and-mortar retail business model go on such an incredible rally? The answer, as often is the case on Wall Street, is speculation—a form of it, in particular, that’s known as short-selling.

As an investment strategy, short-selling is widely deployed by hedge funds and other institutional investors, to varying ends. But the moves of major market players alone don’t account for GameStop’s remarkable ride; there is also an online army of millions of ordinary retail investors—most notably mobilized via Reddit’s r/wallstreetbets forum—who have thrown a spanner in the works, after effectively calling major GameStop short-sellers on their bluff.

The result has been a historic, near-unprecedented situation on public markets: a combination of rampant speculation, online crowdsourcing, and digitally-enabled market machinations—not to mention loads of memes—that could only take place in 2021.

But first, let’s get to the basics of what’s going on—beginning with short-selling itself.

What is short selling?

Simply put, shorting is when an investor bets that a given stock’s price will decline—a reversal of the market’s usual buy/sell machinations, wherein most investors are buyers betting a stock will appreciate in value. 

In order to short a stock, an investor borrows shares in a security at a given price, and then immediately sells them on the market. At some point in the future they’ll need to give the borrower back the same amount of stock they borrowed. They are betting that as time goes on, the stock price will fall, so they’ll be able to buy it back at much lower price and repay original owner. Should that transpire, then the investor will find themselves with a profit between the higher price at which they sold the security and the lower price at which they bought it back.

Short-selling is a highly speculative strategy that comes with plenty of risks; since there’s theoretically no limit to how high a stock’s price can climb, then there’s also no cap on the losses a short-seller could sustain on a bad bet. But it also serves a purpose beyond simply betting on a stock’s losses; many investors use it as a hedging tactic, to offset the downside risks of their more optimistic, “long” positions in the same security or sector.

What is a short squeeze?

What happens if a lot of short-sellers bet against a given stock, but the stock starts to rise? Then you get what’s known as a short squeeze—something at the core of GameStop’s recent run-up.

Once a heavily shorted stock begins to climb on the strength of investor optimism, short sellers begin to feel the losses, and find themselves needing to buy more shares to cover their (losing) position in the stock. But the higher a stock’s short interest (the percentage of its total shares that are being sold short), the fewer shares available for those short sellers to buy—a supply/demand dynamic that sends shares even higher, further exacerbating losses for shorts.

What is happening with GameStop?

With a short interest north of 130%, GameStop found itself heavily shorted by speculative Wall Street investors who were betting on the company to fail. Enter the folks at r/wallstreetbets—a community of millions of retail investors whose combined, collaborative interest in GameStop stock raised demand for the stock and began to drive shares higher this month.

As GameStop’s stock gradually approached, and then exceeded, $100 a share this week, short sellers—including major Wall Street hedge funds who found themselves bleeding money—flocked into the market to cover their short positions. That’s sent GameStop to its current, previously unthinkable levels, much to the chagrin of shorts and the delight of retail investors and market observers around the globe.

Why are other companies now involved?

Word of mouth can be a powerful thing, and forums like r/wallstreetbets have allowed enormous communities of online investors to mobilize in search of opportunity. Just as many sensed an opportunity in GameStop—a struggling yet relatively stable company whose demise had been heavily forecast by Wall Street prognosticators—so have they flocked to similar companies with high short interest levels. Those include movie theater operator AMC Entertainment, home goods retailer Bed Bath & Beyond, and headphone manufacturer Koss.

Yet other companies have seen their stock rally for little to no apparent reason beyond investor enthusiasm—including Finnish telecom player Nokia, which surged despite not having the short interest profile of other firms. 

What happens after a short squeeze?

Once investors begin to settle and exit their positions and demand for a stock (presumably) begins to recede, so does the short squeeze ease, which usually sends shares back down to more conventional, fundamentally sound levels.

Already, some of the stocks affected by the current short squeeze trend are seeing their shares deflate, particularly after Robinhood and other online stock trading platforms curbed trading of those equities on Thursday.

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