Ever since the first stock markets developed in the early 1600s, short selling has been a market tactic. Short sellers sell shares they don’t directly own, planning to eventually cover this short position by buying back the shares, at, they hope, a lower price. The short seller will either borrow the shares from an institution or other investor to deliver to the buyer or at the very least prelocate shares in the event of a required delivery.

A short sale expands the open interest in a stock. If there are 1,000,000 Acme Diversified shares issued and outstanding and 300,000 shares are sold short, there will be 1,300,000 shares owned (or long) since there have to be buyers for the short sales. The larger the short interest, the greater the risk of a squeeze, where the shorts are unable to borrow enough shares to maintain their short position.

There are impediments to short selling. The margin requirements are generally much higher than for corresponding long positions and it may be difficult to borrow or locate shares, particularly if there is a large short interest. Critics also point out that the potential gain on a short position is 100 per cent, while the potential loss is unlimited if the price of the security rises.

The biggest risk involved is a short squeeze, where prices are rising and the shorts can’t find the stock to borrow. This doesn’t happen often, but when it does, the results can be dramatic.

Short sellers are generally unpopular. People don’t like them because they are seen, like the wrong way player at the craps table, as betting against the market. In times of market turmoil, short sellers are often blamed. In many countries, the practice was banned or restricted during the Great Depression, after the 1987 market crash, after the 2001-02 tech bubble crash and during the 2008 liquidity crisis.

Who are the short sellers?

Short sellers may be investors who simply believe that a stock is overpriced (and that they will profit when the stock falls to its true level). No mystery, just the mirror image of investors who buy what they think are undervalued stocks.

The greater the interaction of diverse views on the value of a security, the more efficient the market.

Another group are hedgers. In 1949, Alfred Jones, an astute but little-known public servant, was writing about how to isolate market exposure by buying stocks and shorting the market in a specific proportion. In Jones’ model, market exposure = (long exposure-short exposure)/capital. In other words, Jones pointed out that one should buy an undervalued stock and sell short the market. Jones’ long/short approach provided the basic principle of modern hedge funds — which is to isolate the analytic talent of the advisor from the vagaries of the market. Many hedge funds have a mandate that includes selling short securities and/or derivatives.

A third and less transparent group are the so-called activist shorts. Their strategy is to target poorly-run companies, or companies acting dishonestly (such as cheating on their financials), establish short positions, publish their reasons and force management and the Board to change their behaviour (or get the Board to resign). But not all activists have benign intentions. Some create large short positions and then publish misleading information to get others to join.

In 2019-2020, at least two well-known U.S. hedge funds, Melvin Capital and Citron Capital had targeted GameStop (GME), a retail gaming company, as a good short target for their long/short funds. GME was founded in 1984 and had, until recently, enjoyed success with its instore video games sales and exchanges. It had over 5,000 stores, but the traditional retail business model was no longer working well. The company had lost its competitive advantage to online gaming companies that were focused on customers who wanted to download games — reflecting both changing tastes as well as the impact of COVID-19. By 2019, GME was losing money and was in the process of closing hundreds of its stores.

During 2020, Ryan Cohen, a co-founder of Chewy.com, an online pet-supply company, had bought in to the company to the tune of about $76 million and GME had moved up on the news. By year-end 2020, it was trading around $15 — well above the value that the hedge funds thought it was worth. Melvin Capital and Citron Capital were now heavily short GME. Then, in early January 2021, despite its relatively weak business and the fact that it was neither a value proposition (not trading at a bargain) nor a glamour proposition (little growth prospects) the GME stock price literally exploded.

What was going on?

The story was that retail investors, part of a chat group called r/WallStreetBets on Reddit, a social-news network, were not only buying up the GME stock but also posting messages about their purchases and in some cases, exhorting others to join them. The r/WallStreetBets group isn’t new; it started about a decade ago and has millions of users. The group started a buying deluge. It is very easy to trade small quantities today using online services, direct trading accounts with $10 or less commissions, and investing apps, some of which have free trading accounts.

By late January, the chat line investors had pushed GME stock to a supernatural $150 per share. It was a showdown between the Main Street chatter of investors and the Wall Street hedge funds.

On one side, the apparently powerful hedge funds were providing explanations of why they were short and staying short. On the other, the r/WallStreetBets traders published their own reasons for why they were buying, and their intentions to buy more. The r/WallStreetBets group and other chat line traders were not only buying GME — they were buying and talking up some other companies with large short positions including AMC Entertainment, BlackBerry and Koss Corporation. Big names such as Elon Musk joined in the activity, and his tweet about Gamestonk further galvanized the chat line traders. At one point, GME traded as high as $483 a share, giving the company a market value near $24 billion — about 80 times greater than its closing 2019 value.

In the short run, the r/WallStreetBets group had won, hands down, and the hedge funds were caught in a classic rising-price short-squeeze. With enormous losses piling up, huge margin calls and no stock to deliver, Melvin Capital and Citron Capital (and possibly others) gave up, covered their shorts, and swallowed their enormous losses.

I checked the r/WallStreetBets group website daily in late January to see what was being posted. The website was filled with comments and questionable data about short sales, fails, and that the short squeeze was still to materialize. "It’s not going away so fast"; "It’s far from over, get ready for the second squeeze." Many of the posts were quite aggressive, if not hostile. For example: “Please read if you’re feeling GME burnout: I’m stepping away, but I ain’t (expletive deleted) selling.” And then, the buying momentum ended with a whimper. With the shorts now out of the market, the buying in GME dried up, the bubble burst, and the stock sunk back to the $50 level in early February.

This entire scenario was in some ways a twist on a Ponzi scheme. The early buyers and chatterers made a fortune (for those that got out) and the latecomers who bought at $300 and up or the stubborn ones who refused to sell were left holding the bag. The losers had the wrong enemy in their sights: It wasn’t the hated hedge funds; the latecomers had been conned, either willfully or accidentally, by the early birds.

Some key takeaways

1. Short sellers may be unpopular, but their role remains important in aiding the price-discovery process and providing liquidity. The greater the interaction of diverse views on the value of a security, the more efficient the market.
2. This type of show-down activity will likely happen again.
3. The regulators have been examining the activities of activist hedge funds in distinguishing what is legitimate published information of their views and what constitutes manipulative or deceptive practices. The January showdown will bring a tighter focus as well on the activities of the chat room investors. The regulators will now have to find the right line between simple nonconspiracist chatting and market manipulation.
4. Gravity: What goes up must come down. The market can become short-term inefficient but ultimately, value will prevail, and stocks will find their proper level.

My advice to the r/WallStreetBets group and their compatriots is to heed the words of Adam Smith in The Money Game:

“We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know at some moment the Black Horsemen will come shattering through the terrace doors wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid, no one wants to leave while there is still time. So everybody keeps asking — what time is it? But none of the clocks have hands.”

The fact is, the Horsemens’ arrival is inevitable in every bubble. My advice: don’t get caught.

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This article first appeared in the Spring 2021 issue of Rotman Management magazine. Published in January, May and September, each issue features thought-provoking insights and problem-solving tools from leading global researchers and management practitioners. Subscribe Today!