GameStop And Short Selling: Understanding What Happened

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GameStop And Short Selling: Understanding What Happened



It’s been all over the news recently, but many consumers are still confused. What happened with GameStop and, most importantly, should you be worried about your own investments?

GameStop doesn’t normally capture headlines. In fact, now that it’s so easy to download video games, the game store concept seems a little dated. But the past week has the flailing retailer getting more attention than in its entire 37-year history.

Unfortunately, the news isn’t so good for those who invested in the stock. A group of Reddit users managed to work together to push the per-share price above $300 for the first time ever. For reference, a year ago, that same stock was worth only $4 a share.

What happened could change the stock market forever. But it could also impact you, even if you don’t own a single share of GameStop stock.

Here’s what you need to know about recent events.

How it started

Although the GameStop price hike has been attributed to a group of Reddit investors, the stock price increase actually started earlier in January. GameStop added three new executives to its board–all former Chewy executives. The three newcomers are working to move GameStop to a digital model, an area in which Chewy has thrived. A week after the announcement, shares in GameStop doubled.

That’s where Reddit comes in. Since 2012, a group of investors in a community called WallStreetBets have monitored the stock market. That group took notice of a trend when it came to GameStop. Despite the fact that the company was far from thriving, hedge fund investors seem to be especially interested in it. Those investors were engaging in something called short selling, and the WallStreetBets community decided to do something about it.

How short selling works

Consumers were a little confused about what happened–for good reason. Short selling is complicated, even when explained in the most elementary terms. With short selling, investors see a struggling stock like GameStop and borrow shares in it. Why? Because they can sell those stocks and make a profit.

Here’s how short selling works. An investor pinpoints a poor-performing stock with the assumption the price is going to drop. That investor borrows shares of the stock, typically through a broker, then sells the stock and waits for the price to drop. Once it drops, the investor can then buy the stock back and return it to the original seller at a profit.

For further clarity, let’s go back to a year ago when GameStop stock was selling for $4 a share. An investor might borrow 100 shares and sell them for $4 apiece, or $400. The investor would then wait for the price of the stock to fall to, say, $3 a share, then buy it back and return it to the original seller. Having sold it at $400 and bought it back at $300, the investor would have made a $100 profit.

There’s no guarantee that the price of a stock will drop once a short seller has borrowed it. If it doesn’t, the investor would have to return the stock, having lost the money. If that same investor borrowed 100 shares and sold them for $400, then the stock increased in price to $5 a share, or $500, the investor would lose $100.

The Reddit-fueled spike

So what does this have to do with Reddit? It starts with a group of investors who hang out on the platform. Billing itself as “Like 4chan found a Bloomberg terminal,” the Reddit community WallStreetBets now has more than 6 million members. The community was relatively small until last year, when the popularity of trading apps had more investors joining for tips.

Members first took notice of all the short selling going on with GameStop in September of last year, when a member created a post called Bankrupting Institutional Investors for Dummies, ft GameStop. After the three executives were added to the GameStopboard, members noticed that short selling continued even as the stock price began slowly climbing.

That was when a plan began to hatch. WallStreetBets decided to perform something called a “short squeeze.” That’s the name for what everyone’s been talking about. In a short squeeze, a group of investors get together and buy up a stock, pushing the price up and creating serious problems for short sellers, who can start losing money at an alarming rate.

What does this mean for my investments?

If you own GameStop stock, it’s important to realize this price hike is a temporary situation. You probably know that already, but if you leave your money in, any gains you’ve made could soon be lost. The question is not if you should sell, but when.

But what about your other stocks? You may wonder if your stocks are at risk. If you aren’t actively short selling, nothing is any different today than it was last month or last year at this time. Invest in quality stocks with thriving companies and chances are, anyone interested in a short squeeze won’t be looking at any asset in your portfolio.

Avoiding the short squeeze

GameStop isn’t the only stock being targeted by investors. In fact, there are multiple companies that have caught the attention of investors looking for a short squeeze. Those include American Airlines and AMC–the latter of which has even been mentioned by Redditors.

As of Jan. 28, the companies with the highest short interest are:

  • Ligend Pharmaceuticals
  • Bed Bath & Beyond
  • fuboTV
  • Macerich
  • AMC
  • PubMatic
  • Tanger Factory Outlet
  • Clovis
  • Esperion Therapeutics
  • iRobot

It’s best to avoid trading in companies with a small market capitalization, but that can be relative. Generally speaking, a small market cap is defined as a capitalization between $300 million to $2 billion.

How stop-losses orders can help

Although it won’t protect you from a short squeeze, having a stop-loss order on your trades can keep you from suffering significant losses. A stop-loss order simply instructs your broker to sell if a per-share price drops below a certain level.

But there is one downside to a stop-loss order. Sometimes a stock drops for a brief period of time, only to pick back up again. If your stop-loss order has your broker selling during those quick dips, you may miss out on the opportunity to make money when the value picks back up again.

But what if you don’t have a broker? An increasing number of investors are using tools to broker their own trades. If this is you, check to see if the tool you’re using gives you the opportunity to build a stop loss into your trades.

There is another option that can apply no matter how you’re trading. You can keep an eye on your portfolio and make those decisions on a case-by-case basis. If you’re using an app, you can usually set up alerts so that you’re notified when something dramatic happens with one of your stocks. If you’re using a broker, you’ll still likely login to a portal that gives you features like these.

Summary

The GameStop short squeeze wasn’t the first, and it definitely won’t be the last. Now that you’re aware it can happen, there are steps you can take to ensure your portfolio is stocked with top-quality assets.

Keep an eye on the stocks you’ve chosen and if you notice a stock is flailing, consider whether it’s time to sell it off and use the money to add a more promising stock to your portfolio.





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