Daniel X. Bustamante, Co-Founder and Lead Coach
You must be living under a rock If you haven’t seen or read about the GameStop trade. It has caught the attention of the world at large, governments, and people who have little to no care about the markets.
For me, in 15 years of doing this, it is the craziest thing I have witnessed in any asset class. There is a lot to digest with all of this. Before I start in this post let me just talk to a few points.
Short selling, while some may call it ‘evil’ is a necessary function of the markets. Without it, it creates dislocations in larger hedge funds (whether you like them or not) that will have an effect across other asset classes.
Second. What happened in GameStop as of recently has been going on for a long time in markets. However, this was just something that went haywire.
The Short Squeeze
This all began when Michael Burry (some of you remember him from this movie) figured out that the stock had the potential to trade higher but was being suppressed by ‘short sellers’ and naked shorts that were holding it down. He took a position.
From there one of the founders of Chewy’s took a +13% position and changed the board up. This was the start of the catalyst.
From there the Wall Street Bets Reddit figured out the idea of short-squeezes. In popular culture the Showtime Show, Billions with Bobby Axelrod discussed this idea of short-squeeze in an entire episode.
For those that are interested, it’s a decent watch and they do a good job of explaining what it is here.
In the case of GameStop what occurred was simple but also complex. I am going to break it down:
- Wall Street Bets began to buy out of the money options, in size.
- They began to buy the shares in size.
This created what is known as a ‘gamma squeeze. ’Yes, I get that this is a lot to take in. I invite you to undertake some research on your own. That is if you are interested.
This gamma squeeze led to the increase in price on the shares which followed by, in my opinion, other larger hedge funds attacking the stock by buying shares and driving the price higher.
This is nothing new on Wall Street
This may or may not come as a surprise to many of you that this is nothing new on Wall Street. Is it nice? No, but this is Wall Street and there are a lot of shady things that occur.
While I don’t agree with the extent of the short squeeze on GameStop, or the can of worms that it opens that could affect the overall market-plumbing, it was entertaining to watch.
See, I came from a career where short selling was a way to deliver alpha to investors. In fact, we shorted for-profit education stocks back in 2011 and did well. Was it bad for the people that owned those stocks? Yes and no.
Right now people are mad at the hedge funds and Wall Street in general so I get that. However, short selling provides merit in multiple ways. One of them is exposing fraud in companies.
Again, think about Enron in October 2001 and what happened there. Regulators missed it, others missed it, however, one of the best short-sellers of all times said: “the emperor has no clothes” and uncovered one of the largest frauds of recent times.
Naked Short Selling
The problem, and it has been one for years, is the idea of ‘naked short’ selling… hang with me here, it’s not what you think.
Naked short selling happens a lot, in fact, way too much which creates an unfair advantage for hedge funds and prime brokers. So what is it? In short answer; it allows you to bet against a stock with shares that you never locate a borrow on, so ‘naked short’ selling.
Usually, when you short a stock you have to do what is called ‘locating’ a borrow. Meaning, you need to call or contact the stock loan desk at your broker or prime and get the borrow. What happens is, sometimes, there is no location or available shares, and people short imaginary shares in the market.
(Yea, I probably lost you here! )
But stick with me and, again, research on your own to get a good feel for all of this.
Short Selling as a Strategy
So short selling can create an investing strategy where you can get short squeezes and play the long-side. It can also create opportunities where you can learn to bet against stocks and the market as a whole.
Traditionally, like most hedge funds, they short the shares of companies. Whether you like it or not, it provides a benefit when it is done correctly. So this idea that is floating around of banning it will cause massive repercussions to the markets as it is all interconnected.
Now most of us don’t understand how to short sell and some of the more direct ways to bet against stocks or the markets are through directional puts. In fact, and in my opinion, this tends to be a ‘safer’ way to express the idea to bet against a price of an asset falling.
However, there are other ways to make money from it. Take the GameStop short squeeze for example. What you are seeing is people learning that certain hedge funds short the stock. They are then attempting to short squeeze them by doing what I discussed above.
So whether you want to short sell or participate in the long-side short squeeze there is a strategy to be had.
Now again, while most are, in my opinion, using this event this week to gaslight and lambast hedge funds and Wall Street, let me point out this idea:
If there was no short interest on GameStop, AMC theatres, or even Nokia, then there was no short squeeze and no run up on the stock like there was.
The markets are interconnected in more ways than meets the eye. This makes it dangerous but also beautiful in its own right.
Daniel X. Bustamante