In January, shares of stock for the video game retail company GameStop shot up as traders in an online Reddit forum sought to block an attempt to “short sell” company’s stock. Short selling a stock is a way that a trader can profit from falling stock price. The story became a national sensation and brought the concept of short selling stocks to prominence.
But what exactly is shorting a stock, and how does it work? Matt Farkas is the head of fixed income at St. Germain Investments in Springfield. Farkas joined Zydalis Bauer to explain the complex subject of shorting a stock and what happened with GameStop.
Full disclosure: St. Germain is a sponsor of New England Public Media.
Read the full transcript:
Zydalis Bauer, Connecting Point: In January, shares of stock for the video game retail company GameStop shot up as traders in an online Reddit forum sought to block an attempt to short sell the stock of the company. The practice of shorting a stock being a way that a trader can profit from falling stock prices. The story became a national sensation and brought the short selling of stocks to prominence.
But what exactly is shorting a stock and how does it work? Matt Farkas, the head of fixed income at St. Germain Investments in Springfield, explained the complex subject when he spoke with me recently. And full disclosure: St. Germain is a sponsor of New England Public Media.
Matt Farkas, St. Germain Investments: So, short selling you can think of it as it’s a bet that a stock is going to go down in price and it’s a way for an investor to make money on that belief. So, an investor could believe that ABC stock, it’s currently trading at ten dollars, but really thinks the true fundamental value is five dollars.
So, what a short seller can do is go to his broker, borrow shares, sell those shares, and if — at the current market price of ten dollars — and if the short seller is right in the stock trades down to five dollars, they will buy back those shares to cover the essentially the loan that they have and they will make that profit of five dollars a share. So, if they’re right and the stock price goes down, they make money. But importantly, it’s short selling has…it’s a risky thing to do because of the stock does not go down and it actually goes up in price, you start to lose money.
And unlike when you’re buying a stock, investing a stock, the most you can lose is the amount that you can put into it, because the lowest the stock can go is zero. But there’s no upper limit to a stock price. And so, you know, theoretically, your losses are infinite.
And so, short selling is certainly not something that I would recommend for the average person to do on their own. It’s inherently very risky and it involves a certain amount of expertise around that.
Zydalis Bauer: Now, the GameStop stock frenzy has garnered a lot of attention in the past couple of weeks, where amateur investors organized against short sellers and caused them to have losses because they increased the stock market value of companies. Why has this garnered so much attention?
Matt Farkas: Yeah, I think it’s garnered a lot of attention because it’s such an interesting story, in and a lot of ways it’s a modern story because it involves social media. Short selling has been around for a long time. And the situation that GameStop found itself in was what’s called known as a short squeeze. And I can talk about that a little bit more.
But short squeeze phenomenon do happen in markets from time to time. So, that certainly is not new either. GameStop specifically is a company that some hedge funds had identified as a stock that was overvalued, at least in their belief. And they thought it was going to be going down, primarily because it’s it’s a mall-based retailers selling video games. And both of those areas are areas that I think long-term are challenged. And they ended up shorting this stock in a very aggressive way.
It happened to be noticed by a group of investors. And the investor really spearheading this actually has a local connection, believe it or not. He is a financial adviser, or former financial advisor, for a a locally-based national insurer. And this this gentleman really led the charge in informing people of this massive short position and was really successful in using social media to get his opinion out there, and get people behind his opinion, and really investing in GameStop in a massive way, which caused this short squeeze because as more investors bought GameStop, it pushed the price up.
Volkswagen actually went through this scenario, I think, in 2011. So, about a decade or so ago. A similar type of situation where there were investors that were really short, the stock, it was noticed and investors started to buy the stock in a big way, causing the short squeeze.
Short squeezes tend to be rather short phenomena, as we’re seeing with GameStop. It’s you know, we’re a few weeks into this and the stock prices come down dramatically from its high points. And these things have a way of burning themselves out.
Zydalis Bauer: Are there any ethical implications and attempting to profit off of somebody’s failure?
Matt Farkas: Shorting is a critical part to the market. There are definitely academic studies that point to markets that have participants that are betting on it going up in price, as well as down in price, improves markets. There’s more investors as part of this, so there’s better liquidity, so you can get in and out of those investments easier.
While I can certainly understand people viewing it as problematic or maybe even un-American or something like that, I understand those viewpoints. But again, they are critical market participants and actually do improve markets.
Zydalis Baue: Now, for people who have taken up an interest in the stock market, especially after recent events. What would you tell them to be aware of?
Matt Farkas: I would not call this investing. I would call this more akin to speculation. And speculation may — you know, there’s nothing inherently wrong with speculating. It’s a part of the marketplace. And, you know, if done right, it can be can be effective. But speculation should be done on a very limited basis.
You certainly don’t want to handle your 401k or your retirement funds as poker chips. It’s really important to, if you’re going to be participating in any type of speculation, you do it in a way that’s very limited, in a way that if you do lose dramatically, it’s not going to throw off your long term financial goals.