MarkGruner

What you should know. Why did it happen? How does it affect you? How can you benefit from it? How can you protect yourself from this sort of situation?

Many questions – let’s get some answers!

How

How did this happen? The first thing you need to know is that this stock was heavily shorted. 

Short Position

A short position is where you believe that the stock price is going to go down so you believe the stock price is overvalued. In other words, let’s say it’s trading at $20 but you feel it’s only worth $5. Then what you might do is you short the stock. Taking a short position or shorting a stock is where you buy yourself first, and then you buy later. A short position is highly speculative and risky.

Long Position

A long position is where you buy first and then you sell, which is the normal situation. This is how most investors buy stocks.

The short position is where you believe the stock value price is going to go down and a long position is where you believe the stock prices will go up. A short position is extremely risky because there is no downside limit. Whereas in a long position, your downside risk is limited to your investment. With a short position, there’s no limit to the downside risk. 

Downside Risk

If you buy a stock for $10 and let’s say you buy 1000 shares. You have spent $10,000, the most you can lose is if that stock goes to zero, and therefore you lose your full investment is a $10,000 loss. If the price goes up to $1,000, you’ve just made a million dollars less your investment, so you’ve made $990,000. There’s no limit to how high the price can go. Your upside potential is limitless and your downside risk is limited to $10,000. 

A short position is the opposite. If you short the stock at $20, that means you’re selling it for $20, at the market value. If you short 1,000 shares for $20. Therefore you receive proceeds of $20,000 but you owe 1,000 shares. Now imagine the price goes to $5, therefore, you’ve made $15 per share, or $15,000. The most you can make is if the shares go to $0, in which case you’ve made $20,000. On the other hand, if these prices go to $500. You now lost $480 per share, with 1,000 shares that would be a loss of $480,000. 

This is why there’s no limit to your downside risk. 

This is why shorting shares is very risky. I do not recommend shorting shares under any circumstance unless you put in proper protection and you’re willing to take a loss. If you understand the risks, and you protect yourself, that’s the only time that it’s acceptable. 

Do understand you’re playing with fire by taking a short position. If you want to take a short position you’re much better to take an option that can cover your risk. When you want to protect your position. You are far better off protecting this position by taking an option. But if it’s for a very short period, and you understand the risk, and you’re not shorting, a company that’s already heavily shorted, then you should be alright. 

Heavily Shorted Company

The challenge with shorting a company that’s already heavily shortage is you can get into what’s called a short squeeze, and this is what happened in this case. 

How did this occur?

This required two things to occur there needed to be a spark and there needed to be gunpowder for this situation. The spark was the Redditors increasing the stock prices by increasing the demand for the shares of the company. The gunpowder was the fact that the company was heavily shorted. This will allow a situation where the holders of short positions can be forced to sell and get into a situation of a short squeeze. This will dramatically increase the share prices.

The Spark

GameStop (GME) had a following with some Redditors and they were aware that it was heavily shorted. This is a very important ingredient to this situation. The Redditors could agree to start buying heavily, this will increase the share price if there are enough of them willing to buy many shares of this company for the next many days. This did occur for a few days in a row. Some Redditors felt it had more value than the market price and many people agreed with this, and there was a load of people that was now ready to buy the stock. This will increase the stock price. Now if this happens for several days in a row. The stock prices can go up dramatically more and more people get in because they see the stock prices rising. This will create more people to buy-in. 

The Gunpowder

Then there’s another thing that happens, the people who have shorted the stock start to exit. They get into what’s called a short squeeze and that forces more and more investors to buy. Which then creates a demand for the stock to go up, which in turn increases the price. A short squeeze, coupled with an increase in demand will greatly increase the price and that’s what’s happened here. Now, what happens is all the short-sellers when you have a stock that increases dramatically, those short-sellers are losing significant amounts of money, far more than what they what their initial proceeds were. It can be multiples of the proceeds. For example, if they had proceeds at $20 and now the stock is at $400, that is a multiple of 20 for the loss, which means if you had put in a million shares at $20 you received $20 million, but now you’re looking at $400 million costs or a $380 million loss.

This is why people are forced to get out there are two ways you get out, you realize it’s too high and you cut your losses or you are forced out because your losses are too large. When you close your short position this tends to increase the share price. If you’re holding 500,000 shares, now you have to buy 500,000 shares to close your short position.

Short Squeeze

This is where you get into what’s called a short squeeze. The short-sellers are forced to sell to stop their losses and that, in turn, increases the price which forces more short sellers to incur more losses and forces more to exit their position. Any short-seller that exits their position, needs to buy the shares, which increases the market price of the shares. 

The irony is that the short-sellers hope that the prices will go down, but getting caught in a short squeeze causes the prices to rise due to too many short sellers.

This is what happened and that’s why you get a meteoric rise in stock prices. It is a two-step process, the first step is the Redditors deciding to rise the price by increasing demand. That, in turn, creates an impetus for the short sellers to start exiting their position. The initial spark is the Redditors deciding to buy en masse. 

The Redditors were likely able to cause the prices to rise a few multiples, perhaps from $20 to about $60, but it was the short sellers that created the huge increase in buyers and increase in prices. If you are one of the Redditors now selling to a hedge fund who is forced to buy to close their position, then the Redditor will make a great gain and the hedge fund will have a corresponding loss.

Does this affect you?

Does this situation affect you or me? Not really. Unless you’re a short seller. If you look at my books, I tell people do not get into short positions for any length of time and make sure you protect yourself. I would prefer you use options to protect yourself or you look at the prices and you determine the best strategy to apply where you believe prices will drop. Once you’re willing to risk and what you’re not willing to risk. If you are going to get into a short position, only do so for some hours and only do so with a very regimented stop loss, and make sure that you’re willing and ready to incur a possible loss. 

If you’re going to go for a longer period and you believe in stocks are going to go down, rather than getting into a short position, it’s far better to go for an option, a put option can achieve the same thing with far less risk. To find out more about these things. 

Please download my free book on investing – you can get it here:

You can also find more detailed information on Amazon for the following books:

Investor not Trader

I would recommend that you do not invest as a trader, but you invest as an investor, the difference is the length of time and the techniques and strategies you use for investing. Day traders will often use short positions but these are very risky. This is why I recommend that you start investing as an investor and then if you’re inclined you move to a trader but your main portfolio will be on the investing side as an investor. 

Then you can play around with some small funds as a trader, but please have a look at my books, this is all explained in far more detail. Do not become a trader, without first being an investor. 

If you are to become a trader, make sure you start small. If you can afford $2,000 to throw away, start at $2,000. Assume that whatever you’re going to start with you’re going to lose very quickly. Do not do anything too risky, such as taking short positions. 

Understand first

It’s very important before you take on any trading activities you understand what you’re doing. You do not want to lose your life savings. Please see the risk involved and please read a number of my books on the topic before you start any type of trading activities. 

To learn more – download this book!