Blog Podcast Alternative Investing: Gamestop and The Big Short (squeeze)

Alternative Investing: Gamestop and The Big Short (squeeze)

date February 10, 2021 time 13 min read 512 views

On this episode of Alternative Investing we’re discussing what happened with GameStop and how short selling (aka squeezing) brought high-flying hedge funds to their knees. 

Please use the Spotify link below, or if you haven’t got time, check out the transcript.

You can also listen on Apple Podcast, Deezer, Spreker and Podcast Addict

Remember: All investing involves risk. The content of the podcast is for informational purposes only and is not investment advice. Please always use caution and diversify.

CHRIS: 

Hello and welcome to the sixth episode of Alternative Investing with MyConstant. My name is Chris Roper and I’m the head of communications at MyConstant. With me here today is —

PETER:

Peter, community manager at MyConstant.

CHRIS:

So, Peter, have you been watching the news lately? 

PETER:

I watched a little bit of what’s happening in the investing world. Well, besides Bitcoin being way up? 

CHRIS:

Beside that, what’s the bigger issue that everyone’s talking about right now?

PETER:

Well, these days I’ve been hearing that there have been some shorts afoot, some shorts have been squeezed. The big short squeeze. 

CHRIS:

Would you like to key our listeners into what that actually is?

PETER:

Yeah. So if you have heard in the news GameStop the big game seller and video game seller. Basically, a bunch of people on the forum, Reddit, decided to get together and pump the price of GameStop up very high because they realized a bunch of hedge funds had shorted the stock.

CHRIS:

So how much did it go up? Give me some figures. 

PETER:

So they launched it from about $20 to roughly $347 at its peak. And it has since plummeted down to about $90 dollars where it’s been holding more or less.

CHRIS:

Okay, so just to summarize then, if you haven’t been reading the news lately about investing, a group of people on Reddit and Reddit thread called WallStreetBets, they all banded together through a coordinated push and bought into stock for at bottom to gain stock. 

They pushed the price up massively.

And that seems to be a kind of rebellion against the hedge hedge fund short sellers. And that is what we’re going to talk about today.

We’re going to talk about short selling, what it is, why people do it. We’ll talk about some examples of short selling, because you will definitely have come across it before in the news, even if you’ve never really understood what short selling is.

PETER:

Just like the movie, The Big Short. 

CHRIS: 

That’s right. Yeah. We’ll talk about that in a little while. So just to go back to the GameStop action, in the past couple of weeks, there has been quite a bit of backlash from institutional investors sort of getting together, saying, why are you guys doing? 

You know, you’re pushing the price up and it’s artificial and there’s accusations of market manipulation and things like that. But why are the hedge funds on Wall Street so worried about this coordinated push on GameStop?

PETER:

Right. Well, there are, of course, many reasons.

It’s hard to know why everyone is worried about this, but hedge funds for years have exerted a good deal of control over the markets.

By nature, they have lots of money in the billions, usually because they’re accredited investors and they have a lot of ability to push the news around stocks, things like that, to follow a narrative that might make a stock go up or down. 

It’s difficult to prove in many cases, but there is some reason to believe that hedge funds have even paid to drive the stock price up or drive a stock price down based on just to answer it.

CHRIS:

Sorry to interrupt you there, Peter, but you hit on a very important point. Because I think a lot of us, when we first start looking into stocks, we think, well, people only make money when stocks go up. But that’s not the case, is it? 

PETER: 

No, not at all. 

CHRIS:

That’s exactly what a short is. And that’s probably a great point as well, where we could talk about what short selling is.

I’ll give you my version and then Peter, you can elaborate if necessary, that would be great. But short selling is when you borrow shares that you then sell on the market and if the market falls, you buy the shares again at lower cost and return it to the borrower profiting on the sale.

However, if the market price of those shares rises, you can’t sell without losing money. 

PETER: 

In fact, often you will be forced to buy back the shares to keep because you don’t want it to go so high that you lose even more money when you eventually have to give the shares back.

CHRIS: 

That’s right. It might be easier if we worked through an example. So let’s say Company X is about to release its yearly earnings report.

Maybe I’ve been reading the news and I’ve seen that their products that they make have been getting bad reviews. So I think that Company X is overvalued. 

Let’s say it’s their $100 per share. And I think that’s a bit pricey considering the problems they’ve had with their products.

So I decide I want to short company X’s stock. So what I would do is I would go to Peter, who is my broker dealer, and I would need a margin account with Peter, which is kind of like a credit facility where I can borrow a share in Company X. 

So then I take my share and I sell it on the market for $100. So you borrow the share, you sell it immediately. I now have $100 but I haven’t made any money yet because I still need to return the share to Peter. And every day that goes by I have to pay interest to him on this borrowed share as well. 

So Company X then publishes its yearly earnings report. The news is bad, just as I suspected, and the share price drops to $75. I then take my $100 and buy back that share for $75. Give the share but Peter and then keep the $25 for myself.

This is how you make money short selling. That’s the speculative part. That’s how people can make money by betting against the market, basically or betting against a company. 

However, the flip side to that of course is if the yearly earnings report is as good and the company actually does better than I suspected, then the share price could just as easily rise and keep on rising until infinity. Which leaves me indebted to Peter for a potentially large sum, which is what Peter said earlier.

I would have to at some point decide, OK, I’ve lost this one and buy the share anyway. Otherwise, every day that goes by and the price rises, I’m losing money.

PETER: 

And this is the strategy that causes the short squeeze that we saw with GameStop. So the people on Reddit, they knew companies were shorting GameStop. And so they knew if they drove the price just high enough that the shorts became unprofitable, the hedge fund would then be forced to buy back the stock that they shorted and which caused more stock to be bought, which caused the stock to shoot even higher. So this is a strategy that is sometimes, I think, even used by hedge funds to squeeze each other out and get a little bit of extra boost to a stock price if they know somebody is shorting.

CHRIS: 

Yeah, it’s a push and a pull. There’s a push and pull between the short sellers and the people who are buying in anticipation of the price going up. 

So why do they do it? I think it’s fairly obvious, mainly for speculation. I think there’s a lot of money in this if you can time it well. But there are also some good examples like you can use short selling to hedge.

So hedging is a bit like diversification. If you’re really interested in investing in a particular stock, if you’re unsure whether the price will go up or go down, you could open a sell position, a short selling position as well as buying. A share in the stock, so there are multiple ways you can do it, but I think. 

PETER:

When you’re running a hedge fund, you want to guarantee returns and sometimes the best way is to prepare for the best and the worst. 

CHRIS: 

OK, so we’ve spoken a bit about what short selling is, why people do it. Let’s have a look at some big examples out in the wild.

PETER:

I’ve got one for you really quick, actually. Guess what the first company to ever officially get short sold was.

I imagine it’s a technique that’s been around for a while. So I’m going to say probably General Electric or General Motors. 

PETER:

Wrong. It was the East India Company.

CHRIS:

Oh, wow! Do we know why it was being shorted at the time?

PETER:

So I got this out of a Quartz article. Shout-out to Quartz. They had a disgruntled former board member or something like that. He used to be up in management and he was forced to leave the company. 

And he got so angry he opened up a short position with some bankers and then he printed out basically a bunch of news saying that they would not meet their trade agreements.

They were cutting quality. They were doing all these things. He paid for a bunch of news to drive the price down. This caused East India Company to freak out. They talked to the local authorities saying, look, all these people on our stock, they’re going to not be able to feed their kids. 

The authorities bailed them out and the shorter lost everything, and that they made shorting illegal for a brief period of time in Europe.

CHRIS:

Yeah, shorting can have quite, quite big implications for the market. And that brings us very nicely into another one, perhaps a more recent one and also one that might have affected you financially in some way.

Peter, do you know of a man named Michael Burry?

PETER: 

No, no, the name doesn’t doesn’t ring a bell. 

CHRIS: 

Well, he used to be a neurologist, but then decided he wanted to go into stock trading and investments full time so he set up a company called Scion Capital. 

And Michael Burry was one of the first people to realize that much of the US financial markets were stacked like a house of cards — the US subprime mortgage bond market. So if you cast your mind back to 2008, 2009, you remember we had one of the worst financial crises in a century, at least since the Great Depression.

And what was happening was prior to the financial crisis, a lot of loans were going to people who really couldn’t afford to repay them — subprime lending. 

So subprime is a term used to describe lending to people that might have trouble repaying people who perhaps are jobless or their jobs don’t pay much or they have poor credit histories. But from 2004 to 2006, subprime lending in the US rose from 8% to 20%, which is a massive increase. And at the same time, more people were buying property as an investment. 

Credit was very easy to get, and many people were encouraged to take one more take on more credit than they could afford, which meant the period up to 2008 was symbolic of both risk and speculation. 

But worse — you have this base layer of what was going on. But then on top of that, there was the securitization of mortgages. Now, what does securitization mean, Peter? Any ideas? 

PETER:

That’s where you turn to security?

CHRIS:

You basically hit the nail on the head is where you take an asset and you kind of break it up into tradable securities.

Now, on top of the subprime mortgage market, they’ve created a bond market which allowed traders as well as unscrupulous lenders to speculate. 

So they would trade these bonds back and forth and create even more complex financial instruments on top of this subprime mortgage market, which made the whole system a very precarious house of cards that could collapse at any moment.

The strange thing is that very few people notice this problem. I don’t know if it was just a case of people blinded by their own greed or if it was more a case of, you know, nobody was looking at it. So why should I look at it? But this guy, Burry, the former neurologist turned investor, he looked a little deeper into this and he was one of the first to foresee the coming crisis.

Now, what did he do next? He basically created the first serious short of the subprime mortgage market. He did this by betting against the subprime bonds and he did it using an instrument called a credit default swap.

Now, this might sound quite complicated, but all it is, is an insurance, should the underlying loans go bad. So if the subprime mortgage market collapsed, then the people selling Burry the credit default swaps, the insurance would have to pay out.

So Burry persuaded investment bankers to sell them these credit default swaps. And when the underlying loans defaulted, the investment bankers, they had to pay out, which they did — in droves. 

In fact, Wall Street’s deal with Burry actually cost them millions and millions of dollars. And Burry wasn’t the only one either who bet against the market. 

Charles Ledley and Jamie Mai — they were another two. They bet against the loans and the financial institutions that were issuing them. And they knew that when the loan pools defaulted, everything, including the institutions that sold bonds on these pools, would come crashing down, too, and they made over $100 million dollars out of it. 

Now, whatever you might think of these people, whether it was ethical or moral or whatever, it’s important to remember that the system was at fault.

Not the short sellers. 

As a result of building these increasingly complex financial instruments, the US government then had to bail out the banks to avoid them collapsing completely. So I think you could think of this whole situation just being like a snowball effect. You know, they built a house on sand. 

The sand is the subprime mortgage market. They built all these complex financial instruments on top of it. And then when the bottom collapsed, well, everything else came down to the people who saw it first, could then bet against the market using short selling. 

And they did do really well out of it. 

But one thing I will say, although the government did have to bail out the banks, they did create some new financial legislation to prevent something similar from happening again. 

And this just, I suppose, is another reason why you shouldn’t really rely on the banks alone to safeguard your financial future. They’re run by humans like you and I. And humans are the same everywhere. We’re all a bit — we’ve all got an element of greed and selfishness. And we can be a little bit self-absorbed at times. And I don’t look at the bigger picture.

Maybe one day we’ll have AI to make all our decisions for us. That be quite cool, wouldn’t it?

PETER:

Yea, for sure.

CHRIS:

So that’s short selling in very general terms.

PETER:

And I think I like the big short story because it is an example of the short sellers being the guys taking it to the big guy.

I think with the GameStop story, a lot of the narrative was, you know, the hedge funds are the shorters, so they are manipulating the economy. Shorts are a malicious tool used to get the profits off the backs of people losing money. And throughout history, often people have looked at them that way. But I think the big short was an example of maybe the opposite case.

CHRIS:

OK, yeah. I mean. It’s an interesting one. 

I don’t think you could say short selling was an inherently malicious trading strategy. I think it’s fair enough to bet on a company going bad as it is to bet on a company doing really well. 

The ethical question comes in when a company starts doing poorly and their stock price starts to fall, then the short sellers can exacerbate that. 

They can make that fall much worse than it had been had they not shorted it.

But these are the markets in which we play. And I think the creditors in many ways are doing a similar thing to short selling, just just the opposite. It’s a coordinated buy effort and as opposed to a quiet and coordinated sell effort.

PETER:

In a way, they’re putting out false news, maybe that everyone’s buying, everyone’s holding.

CHRIS:

But yeah, which then becomes what is known as a “pump and dump.” And if you’ve never come across that phrase before, you might.

It’s used quite a lot in cryptocurrency trading because, as you know, crypto is very volatile. It’s a market that’s yet to mature. It’s getting there, but it’s still immature in many respects. 

And because of that, people are investing in something that hasn’t perhaps hasn’t quite demonstrated its value yet. So that makes it extremely subjective to the news. And a lot of people in the world, a lot of crypto communities, they can push out a lot of news simultaneously using the power of social media to inflate the price of a cryptocurrency and then they sell and then the price that’s that that’s so inflating the prices at the pump. 

You get everybody excited, you get everyone pumped up to go and buy the stock or the cryptocurrency, whatever, and then later you sell off and that is the dump. That’s when you just dump the shares or cryptocurrency or whatever back on the market. 

So it’s not very fair. And then people can lose the money that way. So I just want to stress at this point, if you’ve been following everything so far, you might be thinking, oh, short selling sounds interesting. Maybe I’ll give it a go. 

Before you do that, please bear in mind short selling is a very, very risky strategy, especially if you’re doing it for speculative reasons. If you do, try it, please only invest what you can afford to lose.

PETER:

The big issue with short selling is it is a limit to how much you can make and there is no limit to how much you can lose.

CHRIS:

Correct. And that’s the big one. If you ever have options like short selling, things like that, they’re done by the professionals because they have a lot to lose and they have a lot of information.

It’s a popular strategy among hedge funds and investment institutional investors because they have the influence and the weight to perhaps affect the market more than, say, the individual investor does. But anyway, let’s say you are going to try short selling. How can you make sure you’re not going to lose your shirt as a result? 

Peter, any ideas?

PETER:

I’ll be honest. I think there are very few. There are very few ways to know for certain that you will not lose your shirt on a short sale. Because of its nature, it’s an unlimited loss if you’re wrong. because what you do, you’re getting it total. You’re getting out on loan and if it goes up, you’re done the other way round, the lowest the stock can go is zero. That’s the most profit you can get is when the stock goes from whatever it is to zero. 

Yeah, it’s really something you do to hedge against risk. It’s something you do to, you know, squeeze a little bit extra profit out of what you’re earning. I do not think anyone would say it is a great core strategy.

CHRIS:

Right. I think the key thing to remember if you’re going to short, is that it’s all about timing. It’s not something you can do and sort of leave for yourself. It’s something you need to be on top of and keep your eye on.

PETER:

And there are better options, too, for the average investor, if you think of stocks is going to go down. Options trading is a lot less risky of a process.

Chris: 

Yeah, we can discuss options trading maybe in another episode. But just finally, to close off this close off this episode, we talk a lot about diversification. 

And I think if you’re going to follow a short selling strategy, then you do need to be properly diversified to help absorb any potential losses. And of course, we believe alternative investments are a great way to do that. Why is that, Peter?

PETER:

Well, stocks are volatile, traditional markets are volatile and controlled by a lot of factors outside of what you can control, alternative investments that you get into, other things that maybe you’re not so exposed to the forces of nature and they’re a little bit more market resistant.

CHRIS: 

Yes. So if you’re investing in something like wine or collectibles or art or popular loans, peer-to-peer loans like collateral backed can help protect your returns. 

OK, well, I think that sums up everything we have to say about short selling at this stage. As ever, please remember, this podcast is for informational and entertainment purposes only. This is not investment advice. And please always use caution and diversify and do your own research as well. 

Any final words, Peter? Yeah.

PETER:

Hey, we’d love to hear from you guys about what you think of our podcast. Feel free to send us an email at [email protected] or [email protected]

If you have any thoughts about what you’d like to hear on our podcast or something you’d like to see us do. We’d really appreciate anything. This is for the community.

CHRIS:

We’d love to answer your questions in future episodes. And if there’s something specific you want to learn, let us know, because this is for you. 

And on that note, we’ll say goodbye. Thanks very much for listening. 

PETER:

Thanks so much. A good one.

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