If there’s one thing you can say about working in financial services, it’s that there’s never a dull day. This can be exciting, and it can be unnerving. It can also be hilarious. The GameStop story has all three elements. Some background: Selling a stock short is the opposite of buying a stock. When we buy a stock, or go “long,” we are betting that the stock will go up in price. “Shorting” is when a speculator borrows shares of a stock they don’t own (from a brokerage firm) and sell it. They hope it will drop in price so they can buy it back at a cheaper price, return the borrowed stock and keep the difference between the sale price and the purchase price. It’s a very risky strategy.

Here’s why: the most money you can lose when you buy a stock is the amount of money you put up. If you put $10,000 into Apple stock and Apple goes out of business, you lose your $10,000. Selling short however, means you can theoretically lose nearly an infinite amount of money. A stock can only drop in price to zero but it can go up in price forever. Imagine selling Apple short at $5.00 a share in 1985 because Steve Jobs quit the company. It immediately dropped to below $2.00 a share but we know how that story ended.

The GameStop story involved some short sellers, in this case they were hedge funds, one of which had a massive short position. The company was in trouble for reasons similar to why video stores went away, GameStop sells video games and gamers now buy them online. An amateur group of investors that discussed investment ideas online knew of this big short position and decided to pool their resources and buy GameStop stock in an effort to force the hedge funds to “cover their shorts” or buy the stock themselves because as it went up in price, they were now losing money. This is often call a “short squeeze” – when the price of a stock that you have shorted rises, forcing you to buy back those shares at a higher price. If there are many short sellers in the stock, they drive the price up as they get out of the position. Other traders see this and jump on the bandwagon driving the stock price up well above its intrinsic value for a brief period of time.

Many investment strategies that hedge funds pursue can be quite complicated. Selling a stock short without buying other stocks in the same industry (or “hedging your bets”), is as risky as they come. This short squeeze was textbook, and the short sellers ran the stock price up to get out of the investment inadvertently allowing some of the amateur buyers from the web site club to make some nice profits.

However, there’s more to this story than meets the eye. The stock became so volatile that certain triggers were set off at various brokerage firms and custodians—trading was partially halted, and many investors were blocked from buying the stock. This seems unfair to some, and after an investigation we will find out if indeed it was (it sounds unfair to us). But it’s not that simple. First, many investors who bought the stock late in this debacle lost their shirts just like the short sellers. Why? Once the short sellers “covered” their bets, meaning bought back all they had shorted originally, the stock price plummeted. Trading stocks successfully means knowing when to get in and when to get out. Lastly, what no news organization I know of investigated was who are the clients of these hedge funds? I don’t know, but it’s not unusual for it to be pension plans or endowments. None of us worry over a wealthy hedge fund manager losing their own money or perhaps even a very wealthy investor client of the fund but there may very well be average Mom and Pop investors who lost money because their pension plan had some money invested with the hedge fund, we don’t know. This would be a sad side bar to this story.

Some takeaway lessons:

1. At Apella Capital, we do not engage in the kind of short selling we saw with GameStop. We do offer some alternative strategies to more sophisticated investors that include covered short selling (or hedging) as referred to earlier. These are strategies that have low correlation to the stock and bond markets and are quite low risk.
2. Understand the difference between investing and speculating. We invest on behalf of our clients. We take a long-term view and diversify away as much risk as possible. Speculating, while it has its place in financial markets, is not what we choose to do. It often carries high risk, can be complicated, and after fees and taxes, the odds are stacked against you. A great rule of thumb: speculate with money you can afford to lose.

Again, our investors were not affected by this volatility and needn’t worry. Always feel free to contact your Financial Advisor about any concerns you may have from stories in the media. We are here to help educate you about markets and in fact, we view that as an essential part of our job.       

Apella Capital, LLC, provides this communication on this site as a matter of general information. Information contained herein, including data or statistics quoted, are from sources believed to be reliable but cannot be guaranteed or warranted. Nothing on this site represents a recommendation of any particular security, strategy, or investment product. The opinions of the author are subject to change without notice. Due to various factors, including changing market conditions and/or applicable laws, the content may not be reflective of current opinions or positions. All content on this site is for educational purposes and should not be considered investment advice or an offer of any security for sale. Please be advised that Apella Capital does not provide tax or legal advice and nothing either stated or implied here on this site should be inferred as providing such advice. Apella does not approve or endorse any third party communications on this site and will not be liable for any such posts.

Diversification seeks to reduce volatility by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market.