Curious Minds… What is shorting stocks all about?
I’ll admit, the allure of trading stocks sounds appealing. Potential for vast profits. Million dollar pay days, who wouldn’t like it? Yet the basics of buying and selling mask an extremely complex system. Levers to numerous to count.
One of those levers was the object of a deluge of news and interest over the past 10 days. Shorting stocks, short selling. A powerful lever. The basic idea goes like this:
I have no apples. Apples currently cost 5 dollars per apple. I think apples really should only cost 3 dollars and I expect apple prices to drop. I borrow 10 apples from Sally and immediately sell them for 5 dollars an apple. I have 50 dollars but I owe Sally 10 apples. If the price of apples falls to 3 dollars, I then buy 10 apples for 30 dollars. I give Sally her 10 apples and have 20 dollars left over.
However, the opposite could happen. If apples rise to 7 dollars an apple, I have to spend 70 dollars to buy 10 apples to pay back Sally. I’m out 20 dollars.
Risky, but potentially worth it. In the example above, consider that the most money that could ever be made on a single apple is 5 dollars, assuming apple prices don’t drop to the point where people are paying you to take their apples(less than zero). Alternatively, apple prices could go up a theoretically infinite amount. Thus the danger.
So what makes this type of investment so worth while? In the example above, Sally is giving me the apples. In the stock market, I never actually own or possess the stock.
The concept of selling something I never owned is probably where most negative reactions come from. Selling something they don’t own and making a profit. The ethics or morality of the situation have long been debated but the driver for the negative reaction comes from the outliers, edge cases in the short selling arena.
Short selling is a necessary and useful component of the market. It conveys context and information about the price of a stock. However, when abused, as some hedge funds do, short selling can be used to manipulate a stock. When a stock is 100 dollars and the short sell is conveying it should be priced at 80, that is a good thing. Unfortunately some hedge funds use short selling to drive the price to 0 or near enough, manipulating the stock. Driving companies out of business.
For a more in depth look, check out Is Shorting Bad? Is Short Selling Evil? I found it to be a good deep dive.
Short selling allows some dubious people and companies the ability to coerce the market in a way that they shouldn’t. They get to make a lot of money off of this practice as well.
Unless of course someone like DeepF***ingValue, aka Roaring Kitty, comes along and hatches a plan.
Lies, Damned Lies & Statistics
Since this week saw wall street and the internet lose its mind, it seems appropriate to jump into the numbers some.
First, let’s discuss the Short Float. From above we know what shorting a stock is. Imagine in the apple scenario that the person who bought the apples I borrowed, then turned around and lent those apples to another person who was looking to buy apples. Now the same apples have been borrorwed and sold, twice.
Investopedia identifies the short interest as shares being sold short but haven’t been closed out yet. At its height, Game Stop shares had a short interest of 140%. The mechanics of short interest are well explained here, but let’s unpack that 140%.
Let’s say there are 10 apples total, and every apple gets borrowed and then sold. Well, it would make sense that we have 10 apples total and all 10 apples have been borrowed and sold, that our short interest would be 100%. Game Stop’s short at its height was 140% which means that if they were those apples, 4 of those apples would have been borrowed and sold twice!
Historically, shorting the apples 50% to 75% is a good way to decimate the apple company. This doesn’t reset the price to where it should be, it manipulates the price to near zero.
Reminder, Game Stop’s short interest was 140%…. Those are insanely high positions to take on a stock.
Let’s add some more apples
Now let’s say that there are millions of apples. And a group sees that the short float of apples is wildly inflated. So they start buying apples at 5 dollars. Demand raises the price to 7 dollars and additional buying fuels higher pricing. Now apples cost 15 dollars each. For those who short sold apples at 5 dollars, they now have to buy apples at 15 dollars, losing 10 dollars for every apple.
Now lets look back at Game Stop. A reddit subgroup, Wallstreetbets, was the catalyst for an increase in Game Stop stock of more than 1500% over the past month. Imagine the price of an apple at 75 dollars when you bought and sold it at 5 dollars.
Now imagine your Game Stop stock being 1500% more expensive then when you shorted it.
Reddit users drove loses of roughly 19 BILLION dollars for short sellers.
Let’s Get Visual
First, average fund growth example for a consumer & Charles Schwab fund for a consumer. 11.81% & 13.50%
Goldman Sachs investment banking & investment management gross profit margin.
Does investing other people’s money pay?
Yes, yes it does.
Setting aside some dough for that Robinhood App IPO?
How did a group of Reddit users take on these hedge funds? Largely through an app called Robinhood with their mission: “democratizing investing.” The Robinhood theory
Then when the Reddit users began to succeed and make the money the markets promised. Robinhood then halted the ability for users to purchase GameStop and other stocks that were seeing substantial rises.
Robinhood’s actions to halt purchasing BUT not selling of certain stocks flies completely in the face of their mission and demonstrates outright hypocrisy. When both Ted Cruz and Alexandria Orcasio-Cortez are in agreement, something is definitely amiss.
Why would Robinhood do this to its users? Time will tell, but here is some food for thought.
Melvin Capital Management had a huge short selling position in Game Stop.
Citadel LLC had 1 billion and now another 2 billion invested in Melvin Capital.
35% of Robinhood’s revenue comes from Citadel.
Robinhood restricted purchasing, causing the stock to drop from a rising 489 per share to a falling 132 dollars per share.
This likely saved Melvin Capital from going bankrupt.
Robinhood is now under investigation by the federal government and has multiple lawsuits and class action lawsuits pending.
Might invest your Robinhood IPO money elsewhere…
The world of AI and ML
This week’s highlight of things happening in Artificial Intelligence & Machine Learning!
Titan! (Not investment advice, just something I find awesome). Titan uses a combination of ML and human capital to provide a investment vehicle for general investing and Roth IRA. They have been voted consistently a high performing “robo advisor” with shout outs in daily research information, hedge fund-style investment, very small minimum investment amounts (100 dollars I believe), and an excellent app. Their fee of 1% is higher than other robo advisor apps.
Their mix of modeling and human capital is an excellent use of machine learning and performance. I am a big fan of their daily email as well, highlighting their top 3 items of the day.
If you are looking for an alternative investment vehicle which is a bit of set and forget, Titan is worth checking out. Cool use of ML technology. And no I do not get paid for this shout out although using my link can discount my annual transaction fee.
Photo of the Week
One of my favorite memories and captures over the years. While my goal is to get new stuff in Photo of the Week, sometimes ya gotta enjoy the oldies.
When I shot the first part of this photo, I was the only person, save for a hiker camping up way on the mountain (can you find the light?), in one of the most visited nature areas in Colorado.
Last week amid the Game Stop craze, Congress woman Alexandria Ocasio-Cortez tweeted about the very questionable behavior of Robinhood in restricting purchasing of certain stocks. Senator Ted Cruz then followed up with a response of “Fully Agree”.
Unity!!!……. and then not.
His “fully agree” tweet was responded to by Ocasio-Cortez with “…but you almost had me murdered 3 weeks ago so you can sit this one out.”
Now I am old enough to remember when lying about the scale of voter fraud in an election was a permanently ban-able offense on Twitter. Accusing a sitting US senator of attempted murder seems dubious at best.
Lying about the scale of voter fraud and claiming a stolen election without evidence is wrong. Lying about a US senator attempting to murder you without evidence is wrong.
The TwitterPool giveth… and then it giveth some more.
Quote of the Week
“Rule number one: Don’t lose money. Rule number two: Don’t forget rule number one.”
And with that, our time is up. Feel free to check out the earlier issues. Excited to see how this format change continues to resonate. I don’t plan on going away from some of the long form articles, but will find a better medium to house them. Thanks All!
As always, if you think someone would enjoy reading, please feel free to share the love.