The last week of January 2021, all we seem to hear about, other than COVID and the pandemic, is how GameStop, AMC Entertainment and the traders on Robinhood are putting the squeeze on the institutional hedge funds who hold large short positions in those stocks.
First, a quick lesson in what shorting a stock means: A short position is where someone feels that today's stock price is too high and expects it to drop in the future. You borrow the shares from someone (and pay for that borrowing - think of it as interest) and then sell those borrowed shares at today's price. You hope that in days/weeks/months ahead, the stock price will drop and you buy up the shares at a lower price and close out the position. You can earn as much as the total amount you sold if the stock goes to zero. But what happens when the stock doesn't drop but instead skyrockets? Each day, your broker asks you to put up more cash to protect the broker as collateral (remember, you borrowed the shares so the broker keeps the cash in case the broker has to go buy the stock). There is no limit to how high a stock price can go. So your potential losses are unlimited.
Back to GameStop (GME). Lots of hedge funds were short GME. They were all betting the company would either go bankrupt or at the very least, see the stock price drop from $30 / share where this all started. But it didn't. The traders and individuals congregating on WallStreetBets on Reddit talked up GME and the stock rose. All the way to $469, making some individuals millionaires while the hedge funds lost billions before they were able to close out and cover their short positions. This is known as a short squeeze. Ignore that GME is now back down to $98 as I write this and many of those individuals who were millionaires for a few days lost it all. They were just happy to crush the big bad hedge funds.
One issue I have is all the talk I've heard this past week from friends who think shorting a stock should be outlawed. They say "what good is a short? Those people are just out to get everyone else. They talk down the company, spread misinformation...". My retort is that yes, sometimes traders who short stocks do talk down a company, but having that side of the story, instead of just the constant bullish BS from the Wall Street Research side is good for everyone. Shorts provide liquidity - someone selling shares. The news and reasons they post for shorting the stock help everyone re-evaluate and hopefully think twice about the company and the prospects for the future. Maybe life and the future isn't always roses. All of this helps provide liquidity in the market (good for everyone), information so everyone has the chance to evaluate it themselves, and keeps balance. These are good things and should be welcomed and embraced. If, once in a while, these short traders get stuck in a short squeeze and race to cover, losing money in the process, so be it. They know the risks. But let them do it. There are other ways to regulate and set rules that keep the market safe and liquid without taking a valuable player out of the market. Besides, sometimes those articles explaining the reasons for shorting the stock are downright hilarious to read and expose real issues. Remember Enron and Worldcom? Their fraudulent behavior was exposed by short traders.