February 1st, 2021
GameStop: Investing or Speculating?
In order to address what happened with GameStop at the end of last week, we must first define short selling – which is, essentially, the act of selling a stock that you don’t own.
This may sound a little strange – but it actually happens!
To expand on this further: short selling means that a client has borrowed stock from their dealer, sold it in the market, and kept the proceeds from that sale.
After making this transaction, the client “hopes” that the market price of that same stock will decrease – which will allow them to buy it back at a lower price, and return it to their dealer. This allows the client to keep the difference between what they made when they initially sold it, and what they bought it for (at a lower price).
The risk, however, is that if this stock goes up in value, then the client must buy it back at a higher price – and suffer a loss.
The question then becomes: how much can this loss be?
And the answer is: infinite – because there is no limit on how high the price of a stock may rise.
Another question you might ask, is: if the client can’t afford to buy the stock back at the higher price, can the client simply wait until the price comes down (even if that takes a very long time)?
The answer to this question is: no.
As the price of the stock rises, the dealer will insist that the client adds more margin to their account to cover the growth of this potential loss. The client cannot withdraw this margin from their account. They must always have enough money in their account to buy the stock, plus some additional funds, to protect the dealer. If the client can’t put additional money into their account to cover the rising potential loss, the dealer will take control, and buy the stock back using money from the client’s account.
So, what is this GameStop “squeeze” all about?
As the stock price rises, some clients who have shorted simply add the required margin to their account, as required by their dealers.
But those who can’t add enough are being forced the buy the stock.
As these mandatory purchases accumulate, the stock prices are driven even higher, causing more short positions to buy – which puts the stock price into an upward spiral.
As you can imagine, when the GameStop stock rocketed up in value (by astronomical amounts almost overnight), this was devastating to the short sellers.
The risk of loss, as mentioned, is unlimited. And:
1. The rules can change at any time during the game. Regulators and/or the dealer may force the clients who shorted to cover their position (i.e. to buy in), at any time.
2. While short, the client is forced to pay to their dealer any dividends that are declared by the company.
3. The dealer may have acquired the stock by borrowing it from the account of another client. If this is the case, and that other client wants to sell their stock, then the dealer needs to find another place to get that stock from, in order to maintain the loan. Oftentimes the dealer will have to go to the client who is short, force them to buy the stock (asap) and give it back, so that the dealer can return it to the other client. This means that the client who shorted may have to buy in at any time, without warning.
4. There is limited ‘visibility’ on the number of short positions (other clients who are shorting on that same stock). So, you are basically playing a game without the ability to see any of the other players on the field.
There is nothing riskier than playing a “game” like this. You can lose much more than 100% of the value of the stock that you shorted initially (as mentioned multiple times – the potential for loss is unlimited).
Furthermore, there is also risk to individuals who jump on the band wagon and buy these stocks during the run up of the price. Some will get lucky and may be able to sell for a higher price than they paid – but others will not be so lucky. The price will almost certainly come back to earth; and they will see the price on their stock decrease significantly in a short period of time.
The media reporting on the GameStop scenario is calling this “investing” – and that the people involved in this upward spiral are “investors.”
This is simply not true.
People who engage in short selling are speculators. In our opinion, they are not investors; and these speculators would be better off trying their luck at a casino (because at least at a casino, you can’t lose more than you wager)!
- Spire Advisors of Assante Capital Management Ltd.
*Assante Capital Management Ltd. is a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.