09 Feb 2021 22:00 IST

GameStop aside, short selling is essential to markets

A person walks past a GameStop store in the Manhattan borough of New York City, US   -  Carlo Allegri | Reuters

Investors can hedge against falling asset prices by selling short and can reduce a portfolio’s volatility

January 2021 saw crazy swings in the stock price of GameStop, an American video game, consumer electronics, and gaming merchandise retailer. On January 7, the stock traded at $18.08. On Jan 27, it shot up to $347.51. One day later, investors cashed in, bringing the stock down to $193.60. Short sellers, desperate to cover losses, bought shares in a frenzy, driving the price up again to $325 on Jan 29. Since then, the stock has steadily declined in value, closing around $64 on Feb 5, still more than thrice the value on January 7.

Wildly swinging share prices in stock markets are nothing new. But GameStop illustrated the risks of short-sellers and shone a spotlight on the dark world of hedge funds, which ordinarily make millions of dollars placing buy and sell orders on high powered computers. It also showed the power of retail investors who colluded on Reddit, the social network, to keep buying GameStop shares to make its value rise and then sell it on January 27, making millions in profits. So far, the action of these investors has not been termed illegal as securities laws do not explicitly penalize retail collusion.

For one hedge fund, in particular, Melvin Capital Management (MCM), January turned out to be a nightmare. The fund lost 53 per cent of its value as its bets to hold vast amounts of positions to short-sell GameStop, went belly up. Billionaire Ken Griffin’s Citadel hedge fund provided $2 billion in bailout funds to MCM to help rescue it.

Short selling has thrived

For as long as markets have existed, short selling has thrived as well. Most small-time retail investors, however, don’t engage in short selling. Many don’t understand it, and even when they do, they shy away from short selling because it is much too risky.

The best way to understand short selling is to not even think about it in the context of complex financial markets. TLDR US, a fan-sourced business news site, explains the concept in simple non-stock terms.

Suppose apples are selling for $1 apiece. You think that the price of apples will likely fall dramatically in the coming week. You go to your favourite fruit seller and borrow ten apples from him on Monday, promising him that you will return them all to him on Friday.

You sell the ten apples for $10 on Monday and wait for the price of apples to drop. On Thursday, just as you had expected, apples begin to sell for just 40 cents apiece. You buy ten apples for $4, return them all to your fruit seller, and pocket $6 in profits.

No future in a Web era

MCM did the exact same thing with GameStop shares. Betting that GameStop, an old-style brick-and-mortar store chain selling video game DVDs had no future in an internet era where everything is downloaded or streamed, MCM borrowed millions of shares from its broker. In the real world, brokers don’t loan away shares for free. They charge interest, plus, MCM has to pay commissions and other transaction fees. Still, MCM bet that it would come out ahead.

Suppose that MCM borrowed five million shares on January 7 at the $18 price, promising that it would repay the five million shares on February 5. Suppose $10 million in interest and commission brought the total value of the borrowing to $100 million.

As MCM watched GameStop’s share price, it was initially concerned that the price stayed steady for about five days. MCM was hoping that the price would fall. On January 12, the price rose slightly. On January 14, the price had more than doubled to nearly $40. Things were just not working the way MCM had bet.

MCM’s GameStop nightmare

MCM faced a choice. It could have borrowed $220 million from a different bank to buy back five million shares at $40, plus commission and interest, and returned them all to its broker. The net loss would have been the $10 million in interest and fees on Jan 7, the $20 million in interest and fees on Jan 14, plus the $110 million loss because shares went up from $18 to $40. So, MCM’s GameStop nightmare would have ended with a total loss of $140 million.

But MCM chose to wait, hoping that GameStop shares would fall. The commitment was to return the five million shares to its brokers on February 5. There was still plenty of time.

On Jan 25, GameStop shares sold for $77. Had MCM decided to buy back shares then, its losses would have been limited to about $325 million.

But MCM chose to wait some more. Hope is after all eternal.

Cashing in, heavy borrowings

On Jan 27, GameStop shares went up to $347 exposing MCM to potential losses of nearly $2 billion. As Reddit investors cashed in, MCM, borrowing heavily from Citadel, rushed to buy five million shares. The huge buy order drove the value of shares up again. Now in the red to a tune of $2 billion, MCM meekly returned the five million shares to its broker on February 5.

If you’re a retail investor who is risk-averse, you’re probably shaking your head at the stupid people at MCM who delivered $2 billion in losses to the hedge fund in just four weeks.

But short selling is essential to the healthy functioning of markets and investing. Even retail investors can buy themselves some insurance by holding both long and short positions on their favourite stock. This way, they can hedge against falling asset prices by selling short. Holding short positions can help reduce a portfolio’s overall volatility.

In a zero-sum game, short selling provides people to vote with their dollars to hold contrarian views about the direction of markets and profit enormously if their bets pay off. Short selling serves as the automatic buffer and cushioning mechanism because greed, the underlying driving force that keeps markets healthy, motivates people to act without pressure from any government or central authority. There is no better example of capitalism’s “the higher the risk, the higher the reward” commandment.