They have often proved to be the first people to notice that a company is in trouble, sometimes even before the company’s directors do. The counter-argument is that you cannot successfully short a healthy company, as your bet will simply turn out to be wrong.įurthermore, short-sellers can act as an early warning system highlighting bad businesses. There is evidence that shorting can accelerate the downward movement of share prices, as big bets on corporate failure become a self-fulfilling prophecy. Several national financial regulators across the world imposed temporary bans on short-selling certain vulnerable stocks – such as banks or insurers during the post-2008 financial crisis – or even blanket bans on the practice. Hedge funds were accused of deliberately driving companies into the ground by taking out billion-dollar short positions, artificially pushing down share prices to the point that they collapsed, when they might otherwise have survived. Hedge funds aren’t exactly the world’s favourite people, given that they make vast quantities of money, often with ruthless disregard for the businesses that become little more than chips in a financial casino game.ĭuring the financial crisis, shorting became a byword for vulture capitalism. This is the fuel that stokes the short-squeeze fire. These are the right to buy shares at a certain price and they effectively function as a leveraged bet, a purchase that only requires you to pay a fraction of the share price. They aren’t only buying shares, they’re also using call options. How can Reddit users afford the buying spree? Effectively they have been forced to bet on shares rising in order to offset their previous bet on them falling. But that buying forces the share price up even more – making their position even worse. The hedge funds have to start buying the shares, in order to “cover” their position and limit their potential losses. The hedge funds found themselves trapped in what is called a “short squeeze”, a kind of feedback loop that drives the price ever upwards. They had suffered losses of $1bn already, according to reports on Thursday. That began forcing the price up – it is now up more than 1800% – increasing the losses for the short-sellers who had bet against it. They decided to punish the Wall Street big boys and launched a co-ordinated buying spree.
In this case, Reddit users in a group called WallStreetBets noticed that hedge funds, including one called Melvin Capital, had taken a large short position in GameStop. Theoretically my losses are unlimited – because there is no defined ceiling on how far a share can rise. I’ve sold the share I borrowed at £10 but if the value increases to £100, I’ll have to spend £100 in order to give a share back to the person I borrowed from. If my prediction is incorrect and StuffCo’s shares go through the roof, I’m in big trouble. I have pocketed £5 by correctly anticipating the fall in the share price. They get their share back and I’ve still got the £10 I sold it for, minus the £5 I had to pay to replace it. So I wait for the StuffCo share price to fall to £5, then buy it and return one share to the person I borrowed from in the first place.
I no longer have the share I borrowed but I will have to give it back at an agreed time. If I sell it straight away, that puts £10 in my pocket. If I expect the share price to fall (because I think it is a rubbish business: badly run, for instance, or selling outdated products), I can borrow a share in StuffCo from someone who has it, in return for a small fee. If the price rises to £15, I can then sell my stock for a profit of £5 per share. If I believe the share price is going to rise, I’ll simply buy shares at £10. Let’s say StuffCo (a made-up company) has a share price of £10. It’s a way of making money by betting that a company’s share price will fall. But a good place to start is by understanding what short-selling is – and how the Wall Street wizards who do it could end up being wrong-footed by a group of amateur traders.