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Writer's picturetomrimer

When the Game Stops

Yes, the title of the post is a bad pun on what has been the big news of the week. Gamestop, along with several other stocks over the past five days, has been on the absolute most crazy rollercoaster ride I have ever seen in my 30+ years as an investor and investment professional.


I have to say, I don’t see anything good coming out of this. But before I get into that, here’s some background and a brief recap for those of you who aren’t aware of what’s going on.


Short Selling


I won’t go into all of the technical aspects of what is happening, but a lot of what has caused this week’s craziness revolves around the practice of “short selling”. This trading technique involves selling a stock before you buy it, which is the reverse of the traditional method of buying a stock and then selling it at some point in the future. A short seller will “borrow” shares of a certain stock with the promise to return the borrowed shares later. The investor takes the shares they have borrowed and sells them, with the hope the price will go down. The investor is hoping to buy shares later to repay the shares they borrowed at a lower price than they sold them for. It’s the same goal of buy low/sell high, just in reverse order.


So essentially selling a stock short is a bet that the price will go down, whereas the traditional buy-then-sell investor is hoping the price of the stock goes up. It’s perfectly legal, though many people are not at all a fan of this strategy, including me.


Getting caught with one’s shorts down


Here is one aspect of short selling that you need to know about to understand one of the major problems with what has been happening. When you sell a stock short, as I said you’re borrowing the shares that you then immediately sell. Essentially you’re borrowing them from the brokerage firm you are using to do the short sell, and like any lender, that firm is going to want some kind of assurance that they will get repaid!


Just as banks want collateral when giving you a loan, a brokerage firm that loans shares to you to sell short will want a certain amount of cash to be kept in your account as a way to back up the stock loan. This level of cash is a percentage of the value of the stock you borrowed; if the price of the stock you borrowed goes up, so does the total value of those shares that you owe. When this happens, you need to do one of two things: deposit more money in your account to maintain the cash percentage required, or buy back the shares you “borrowed” and close out the position. What happens most of the time is the second of those two choices.


The short squeeze


Back to what has been happening the past few days (at a high, not-so-detailed level). A community on Reddit, who were a group of mostly (but not exclusively) young, inexperienced investors, started buying the shares of a few companies that had a large number of “short sellers” (they were also, and really much more so, buying options, which will be the subject of another post in the very near future). When more people want to buy a stock than want to sell it, the price goes up, which is what happened when people started buying in on sites like Robinhood.


And, when the price of GameStop, for example, started rising, the very large short positions in the stock started getting affected in a very bad way. As I described earlier, many “short” investors had to buy stock to repay the stock they borrowed to initiate their short position; this buying pressure caused the stock to rise even further, even faster.


The result was stocks increasing at insane rates over a matter of days and even hours. And as the prices continued to skyrocket, the short positions were largely eliminated. This is known in investment circles as a “short squeeze”.


Paper profits


Obviously, a lot of investors got involved with this at an early stage, and bought into stocks like GameStop well before it climbed over $400. For someone that bought it at $40, for example, the $400+ peak represented a 1000% gain; a 10 times return on their investment! I’m saving the topic of options for an upcoming post, but for now I’ll only say that those that bought the options instead of the stock made an even greater percentage gain. But, how many people sold at $400? Or even 200? Gains on paper look great, but I suspect plenty of people also held onto the stock as it started to fall, and watched the paper gains turn into losses. And it’s still happening: as of the writing of this post the stock is still going up and down like a nuclear-powered yo-yo.


This leads to why I think this whole episode is not at all a good development. First, buying the stocks involved in this week’s craziness entails an enormous amount of risk. Looking at the price charts of these stocks reveals a very rollercoaster-like pattern. As with any stock, you never know where you are on the chart in terms of the stock continuing to head up or down, but with such wild swings, you could lose a very significant portion of your investment in just a matter of minutes.


So the risk level of these stocks at the moment is extremely high. Yes, the reward potential has also been very high, but as I’ve said I wonder how many people who were way ahead on these stocks actually cashed out with a profit. Probably not all that many.


What now?


I’ve had a number of people ask me for advice this week as to whether they should buy into GameStop, AMC, and a few others. I don’t like to give buy and sell advice on particular, individual stocks, but here is what I have been telling people: do you really want to pay $250 or $350 or more for a $40 stock? And when I say $40in the case of GameStop, I’m being generous. The companies whose stocks were involved in this week’s madness are not in very good financial shape. That’s why the hedge fund took short positions: they were betting the prices of these stocks would fall. Oops.


The only way to make money on stocks involved in this week’s rollercoaster is if they keep going up and if you get out before the inevitable plunge back to reality takes place. Two big ifs, made even more difficult by the fact these stocks have been moving at lightning speed up and down literally in minutes.


This is a gamble, pure and simple, and it’s what I call a blind gamble. At a casino you know what the odds are and you know the rules of the game (or can know quite easily if you take the time to find out). You know what the risks are. Using the Reddit strategy, you don’t know any of this.


I’m not going to participate in this strategy, but I’m not going advise anyone else not to do it. I will however repeat what I frequently say about all investing/gambling situations: if you’re going to invest, use money you have set aside to build a long-term portfolio that will grow and improve the quality of your life; if you’re going to gamble, only use play money that you are prepared to lose all of.


In the midst of a very uncertain week, we can be certain about one thing: we haven’t seen the last of what we saw this week. My next post will talk more about this.



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