A Short Lesson on Short Sales

Some people think that putting money in the stock market is investing.

But in the past week we’ve seen the power of social networks to mobilize large numbers of people to undertake an otherwise un-natural transaction en mass, all at once.

The nearly dead company GameStop has been making headlines in recent days. A number of people are probably wondering why Gamestop’s stock has been surging. It doesn’t quite make sense. So before I explain what happened to Gamestop, you need to understand short sales in the stock market.

So imagine you think that a company’s stock is going to fall. Pick a company, any company. You might choose Boeing. Boeing is trading around $197 per share. Let’s say that you want to short Boeing, you borrow a share from a broker and sell it immediately at its current price. You then hope that the stock’s price is going to fall so that you can buy it back at a lower price and return the shares you borrowed to your broker. You make money on the difference.

So if Boeing shares fall to $190, then you could buy the stock for less than you sold it and and profit on the difference. You decide to cover your short position by purchasing the stock and $190 and now you’re in a safe position with a profit of $7.

But if instead of the $197, the stock shoots up to $205, you still need to return your borrowed share to the broker, except now it’s going to cost you $8 to buy back the stock at the new higher price. You would be facing a loss of $8. Since the stock could continue to rise indefinitely, the losses for a short seller can continue to increase indefinitely. You have to replace the borrowed share and the more the price rises, the bigger the loss.

For Gamestop, a few weeks ago someone on reddit on the wallstreetbets page noticed that a hedge fund had taken a massive amount of short trades against Gamestop. The one reader convinced everyone on the thread to join forces to buy as much of the Gamestop stock as possible. This pushed the price up in the short term. The short seller was immediately exposed to billions in potential losses. Eventually the losses grew beyond the $13.1 billion that the hedge fund was worth. Eventually the hedge fund was forced to declare bankruptcy. Now we have the reddit thread combing through other hedge fund positions with massive short exposures so they can short squeeze them into bankruptcy as well.

We’re now seeing similar assaults on share of AMC Entertainment which nearly tripled in value on Wednesday.

Now folks, this isn’t investing. This is called gaming the market. But it’s pitting massive distributed liquidity against concentrated liquidity in the brokerage houses.

Today, 90% of the trading volume in the market is based on large computer based trades that are aiming to squeeze out small profits. The initiative for these trades are software programs written by quantitative analysts. These guys and gals are mathematicians who analyze the performance of the markets and they try to develop algorithms that give a brokerage house, a hedge fund, or an investment bank a quantitative edge in the market. So as a simple example, a computer program that looks at the price of Boeing on the London stock exchange might notice that the stock is trading a few pennies higher in London than on New York. The software would then exploit the price difference by purchasing the stock in New York and immediately selling in London and making a few cents profit on the trade with very little risk. You don’t make a lot of money on each trade unless you through huge volumes at it. Throw too much money at the trade and now you risk eating your own lunch and negating the very price difference you were aiming to exploit. There are dozens and dozens of algorithms that have been created to try and outsmart the market. The folks who do this are affectionately called quants.

To the untrained eye, this is strange. Now you know why.