How Short Bets on GameStop Took Big Slides
The financial news in the past week or so has been full of stories about GameStop, AMC Entertainment Holdings (AMC), Blackberry, Reddit, r/WallStreetBets, hedge funds, short squeezes, margin calls and Robinhood, among other things. Many of these stories explain parts of what is happening. However, they often use terminology that may be unfamiliar. My goal with this post is to help you better understand what is happening and what you are reading.
I’ll start with a brief overview of the news, in case you’ve seen only bits and pieces of it. I’ll then explain and provide examples of the important aspects of the story.
GameStop and Other Companies
GameStop, AMC, Blackberry and a handful of other companies have not been doing well financially for various reasons. Many investors expect the prices of these companies’ stock to go down.
Some hedge funds, most notably Melvin Capital, have been betting that the stock prices will go down by using various tools that make them money if the price goes down.
A large number of individual investors have been buying stock in these companies. Many of these investors “connected” with each other on social media, primarily in the Reddit group, WallStreetBets. When there are more buyers than sellers, the stock price goes up.
These increases cause problems for investors who have bet that the stock price will go down. In fact, due to certain rules, some of these investors are forced to buy the stock to make whole on their bets which pushes the stock price up even further.
Brokers have to have cash to cover the value of any trades that haven’t been settled. Behind the scenes, it takes two business days for each trade to settle. The high volumes of trading over the past several days have increased brokers’ cash requirements.
Robinhood is a relatively new online-only trading platform that is attributed with being the first to offer free trades. Because of its relatively small size and business model, it didn’t have a lot of cash available relative to the volume of trades.
As such, Robinhood and some other brokers had trouble meeting their cash requirements. Some of them therefore halted trading in the high volume stocks. In a few cases, brokers sold the stock of some of their clients without asking.
The Wall Street Journal has a summary of what has happened in the past week with some great analogies, if you have a few minutes for a different perspective.
The companies targeted by WallStreetBets, including GameStop, have two common characteristics. First, they are all facing financial difficulties. Second, there have been a lot of transactions, measured by something called “short interest,” that take the bet that the price of these stocks will go down.
GameStop primarily sells video games from its stores. In recent years, people increasingly buy video games online or play in games that are hosted online. In addition, many of its stores are in malls that have been shut down or forced to limit traffic due to COVID-19 restrictions. As such, GameStop’s business model has become outdated. Unless the business model is updated, GameStop is unlikely to return to being a successful company.
AMC Entertainment Holdings
AMC’s primary business is ownership of AMC movie theaters. Even before COVID-19, streaming services were significantly cutting into audiences at movie theaters in general. In the past year, attendance has decreased dramatically at most movie theaters if they are allowed to even open.
Blackberry was an innovator in smart phones, but has transitioned its business to focus on security software and services. It hasn’t made a profit in the past seven quarters and its revenues have been substantially flat.
Bed, Bath and Beyond
Bed, Bath and Beyond is a retailer of home goods. As with AMC, it wasn’t doing well prior to COVID-19 due to competition from stores like IKEA and target. With the advent of COVID-19, Bed, Bath and Beyond started closing a significant portion of its stores.
Why These Companies?
As you read these stories, you’ll see the common theme that the companies aren’t doing well financially, especially in the current environment. As such, many investors have bet that the stock prices will go down.
On the other hand, these companies are making changes that could turn around their financial situations. Certain other investors, in part prompted by the r/WallStreetBets forum on Reddit, recently started investing in these companies. Their purchases of stock in these companies have driven their prices up substantially.
What are Hedge Funds?
A true hedge fund is a pool of money (like a mutual fund) that hedges its investment risk. A hedge is an action that is expected to reduce the risk of your primary activity.
Examples of Hedging
About a year ago, a friend of mine began to think that the valuation differential between Home Depot and Lowe’s was too great. He thought Home Depot was overpriced and Lowe’s was underpriced. He sold his position in Home Depot and replaced it with Lowe’s. By comparison, a hedge fund might have bought Lowe’s and entered transactions that allow it to profit it Home Depot stock went down.
The hedge or offset does not necessarily have to be a stock. For instance, you might like gold mining stocks but are concerned they might decline if the price of gold falls. To hedge this risk, you offset your stock position using one of the techniques discussed below that wins when the price of gold goes down.
The term “hedge fund” has morphed into a term that describes fat cats that viciously undercut the market with false rumors in an attempt to drive share prices down. There are a few of them. In reality, though, a hedge fund is simply a mutual or other type of fund that uses hedging as an investment strategy.
it is important to remember that, while hedge funds are businesses, they are ultimately owned by individuals. Some of the owners might be considered “fat cats.” However, there are many “ordinary” people who have investments in hedge funds. Some are direct owners, while others are participants in pension plans or own stocks in companies that, in turn, own the hedge funds.
Betting Against a Stock
Hedge funds, and many other investors, use tools that allow them to bet that the price of a stock will decrease. When you buy a stock, you are said to take a “long” position in it. You buy it because you think the price will go up. You want the value of your investment to increase along with it.
There are two tools that are commonly used when you want to profit from your expectation that the price of a stock will go down – short sales and put options.
In a short sale, the investor borrows shares from someone else and sells them. Retail investors, like you and me, borrow the shares through their broker from another of the broker’s clients who owns the stock of interest. For larger investors, there are other mechanisms that allow them to borrow shares. The investor pays interest to the lender to borrow the shares. At any point in the future, the investor can then buy the same number of shares. The purchase allows the investor to return the borrowed shares.
Here’s an example. An investor thinks that the GameStop stock price is going to go down from $20 a share to $10 a share some time in the future. The investor borrows the shares and sells them at $20 apiece. This transaction is the short sale. Let’s say the broker charges 2.5% a year in interest to borrow the stock. If the investor holds the short position for two years, the broker will get $1 a share (2 x 2.5% x $20) in interest over the two years.
If the GameStop stock price goes down to $10 at the end of the two years, the investor buys the shares. At that time, the investor returns the borrowed shares to their owner. The investor has made a $9 gain per share equal to the $20 it received for selling the shares minus the $1 in interest minus the $10 it paid for the shares. The only money the investor has paid out of pocket is the $1 in interest. In the interim, it has had the $20 per share in cash it received from selling the shares.
If, instead, the GameStop stock price went up and showed no sign of coming back down, the investor might have to buy the stock at $30. In this situation, the investor will lose $11 per share equal to the $30 it paid to buy the stock plus the $1 interest minus the $20 it received for selling the stock.
Margin on Short Sales
As illustrated, there is always the risk that the price of the stock will go up in a short sale which causes the investor to lose money. The broker who loans the shares doesn’t want to face the risk that the investor won’t be able to afford to buy the shares if the stock price goes up. To protect against this risk, the broker requires investors to hold money in their account at the time the short sale is made. This money, called a “margin,” acts as collateral for the broker and the person who loaned their shares to the investor. A common amount for the initial margin is 150% of the value of the stock being shorted.
I’ll continue the example from above. When the investor borrows the shares, the value of the position is equal to $20 times the number of shares. I’ll use 1,000 shares for this example, making the value of the position $20,000. The total value of the assets in the account must be at least 150% of $20,000 or $30,000, using the typical margin amount I mentioned above. Remember, though, that the investor has the $20,000 it received when it sold the shares.
When the stock price rises, the margin requirement rises accordingly. If the stock price went from $20 to $30 in our example, the investor would then have to have at least $45,000 of assets in its account. At that point and the broker required the same 150% margin, the investor has two choices if it doesn’t have that much money in the account. The investor can buy enough of the stock at $30 (an $11 loss in our example) to lower the margin requirement. Otherwise, the investor can move money from another account into this account so it meets the margin requirement. The broker’s requirement to either increase the total assets in the account (i.e., the margin) or reduce the short position is call a “margin call.”
I note that brokers have the ability to be flexible on the margin when the stock price changes, so the total amount of margin required in this example might not be as high as $45,000.
In a short squeeze, an investor is subject to a margin call. That investor can buy stocks to cover its short sales. When it buys those stocks, the stock price has always increased from the price at which the investor bought the stock. This difference causes the investor to lose money. The loss on that money further reduces the value of the assets in the investors account making it even harder for the investor to meet the margin requirements.
Perspective on Short Sales
To be clear, there is nothing inherently wrong, illegal or immoral with short-selling stocks. Short sales are a valid strategy for limiting risk. Short-selling stocks is also a valid trading tool, no less moral than talking long positions in stocks.
Where it can go bad is when the short-sellers spread rumors and gossip, sometimes outright fabrications, in order to advance their positions. The same is true for people who fabricate stories to increase the price of a stock so they can profit from taking a long position. Using rumors, gossip or lies to manipulate the price of a stock in either direction is wrong and it is against the law.
Another strategy that investors use when they believe the price of a stock will go down is to buy put options. When you buy an option, you have the choice to buy or sell something, but aren’t required to do it. By comparison, when you short-sell a stock, you are required to buy it at a later date.
A put option gives the buyer the option to sell a stock at a pre-determined price, known as the strike price, by a fixed date. That is, unlike short-sales which have no deadlines, options have deadlines that limit the time frame during which the buyer can exercise the option.
If the stock price goes down before the deadline, the buyer can buy the stock at the then-current price and exercise the option to sell it to the person who bought the put option. When the stock price doesn’t fall below the strike price before the deadline, the option expires and nothing else happens.
As I write this post, the price of Boeing stock is $194.19 per share. The price or premium of a put option to sell 100 shares of Boeing stock at $195 on or before a week from today is $5.72. My broker may charge me a fee for buying the option in addition to the premium. For this example, I’ll ignore those fees.
Let’s say I buy that put and the stock price goes down to $190 at some point in the next week. I can exercise my option to sell my 100 shares stock at $195 per share or a total of $19,500. Just before I exercise my option, I will buy 100 shares at $190 per share or $19,000. My gain on this transaction is $494.28 which is equal to the $19,500 I get from selling my shares minus the $19,000 I pay for my shares minus the $5.72 I paid for the option.
If the price jumps up above $195 very early on the next trading day and never falls below $195, the transaction costs me only the $5.72 I paid in premium.
Margin Requirements on Puts
I don’t believe there are margin requirements to buy puts. I couldn’t find anything that confirms that there are no such requirements. It makes sense to me, though, because the investor can’t experience a loss once the put has been purchased.
How the Hedge Funds Got in Trouble
At first, it might have seemed counterintuitive that hedge funds could get in financial trouble when these stock prices went up. It turns out they had significant short positions in many of these stocks.
I’ll use GameStop as an example. On January 12, the stock price was about $20 per share. By January 26, the stock price closed at just under $150 per share. There are approximately 70 million shares of GameStop outstanding. Let’s say a hedge fund short-sold 10,000,000 shares of GameStop at $20 on January 12. On that date and using the typical 150% margin requirement, it needed $300 million (= $20 per share times 10,000,000 shares times 150%) in its account as margin. When the stock price went up to $150 per share, the margin requirement went up to $2.25 billion (or a lower amount if its broker was willing to lower the margin requirement)!
If the same hedge fund had only $1.125 billion in its account in total, it would need to buy enough GameStop stock to reduce its margin to $1.125 billion. Initially, it could buy 5 million shares to reduce its short position. However, two things happen when it buys those shares. First, when someone buys shares totaling more than 7% of those outstanding (5 million / 70 million total is about 7%), the price of the stock goes up even further. Second, the company has to pay $750 million to buy the 5 million shares which will likely reduce the value of the money in its account. Remember that the hedge fund has to return the shares it bought to the lender. It doesn’t get to keep them in its account. You can see what’s coming next! With less value in the account, it needs to sell more shares . . . .
How Can So Many Shares be Sold Short?
The hedge funds short-sold more shares of GameStop than are outstanding. It took me a while and some help from a friend who is a retired stock analyst to figure this out. Essentially, the hedge fund borrows the same shares more than once.
Here’s an example. Mary buys 500 shares of GameStop. She allows her broker to loan them out for short sales. Hedge Fund A borrows Mary’s shares and sells them to Joe who then sell them to John. John, in turn, allows his broker to loan his shares. Hedge Fund B borrows shares from John, but it turns out they are the same shares it borrowed from Mary! If this pattern happens often enough, investors can short-sell more shares than a company has outstanding.
I’ve read that the shares are supposed to be tagged once they have been loaned. The tags ensure that no shares are loaned more than once. I don’t know why these tags didn’t work the way they were intended.
How and Why Brokers Responded the Way They Did
Some brokers, Robinhood most notably, restricted their clients’ ability to trade in some stocks and, in some cases, sold clients’ shares without their knowledge or agreement. Initially, I saw rumors that these restrictions were to protect the clients from too much risk or to help bail out the hedge funds. The reality is that some brokers were having their own version of a short squeeze, though it wasn’t a short squeeze and isn’t called one either.
Most individual investors are unaware of the process of settling stock trades. From our perspective, it appears that we can instantaneously buy or sell a stock. What actually happens is that the order goes to a clearinghouse. It takes two days from the time you place your order until the clearinghouse settles the trade. In the meantime, brokers are required to have cash as collateral until the trade settles. I have not found exactly how much cash is needed, but it bears some relationship to the market value of the trades that have not settled and the clearinghouse’s perception of the volatility of the stocks being traded.
As investors made more and more trades at higher and higher prices, the dollar value of unsettled trades skyrocketed. Some brokerage firms didn’t have enough cash to meet the collateral requirements, with Robinhood being one of them. When that happened, Robinhood couldn’t accept more trade orders until one or both of its cash requirements were lowered as trades started settling or it acquired more cash.
The information in this post is based on my understanding of what happened. I have no first-hand knowledge. I have done my best to provide a fair and balanced explanation. It is not clear that everything that has happened is completely legal. I will leave it to the Securities and Exchange Commission, among other, to sort out those details.