A quick introduction to the mechanism of stock short selling

Recently a lot of people have been asking me about the details behind the price movement in GameStop (NSYE:GME), the situation is obviously completely absurd but this absurdity has led to people questioning their mental models. This is because, by traditional value investing metrics, none of this price movement makes any sense at all, so people naturally start to question "what am I missing here?".

The last 12 months have seen a lot of absurdity in the stock market. Due to a number of factors from monetary and fiscal policy we have seen a large disconnect between the strength of the real economy, which has been badly hurt by the pandemic, and the soaring prices of equities on the markets. When you understand the underlying causes and market mechanisms it shines a lot of light on why prices are moving the way they are, the absurdity isn't just a pandemic of people losing their minds, but rather reflects on ways in which the modern financial markets are structured which has consequences that seem deeply counterintuitive or insane to people who aren't aware of them. One example that really did seem to just be insanity was when Hertz attempted to do a new stock offering after declaring bankruptcy in mid 2020/ and found that there were people actually willing to buy these new shares. This was a case of a retail investor driven bubble that most obviously had no fundamentals whatsoever, Hertz had already officially declared bankruptcy after all. This was a rather pure case of markets mania which makes it somewhat rare, other movements have tended to be a combination of other factors. For example there were a huge number of pharmaceutical pump-and-dumps with various pandemic related press releases, a great example of this was the speculation and frontrunning of the news with Eastman Kodak with the announcement they were being chosen to be a provider for materials that were important in the pharmaceutical supply chain. These situations definitely had a bit of a bubble aspect to them as well, but it was less obvious that the price action was not based on fundamentals with Eastman Kodak company since the news release that the Trump Administration was choosing them as a supplier was some genuine positive news for the company that impacted the stock.

All of these situations have arisen because the fundamental price discovery mechanisms of the markets have been deliberately manipulated in various ways over the last year. Though this goes back far further than 2020, don't think for a moment that this situation started with COVID, the acute financial crisis goes back to at least the repo meltdown in 2019. The foundations for the current problems were laid with the unresolved events of the Global financial crisis and perhaps are the result of multiple decades of moral hazard becoming increasingly profitable that was started by the bailout of Long Term Capital Management in the 1990s¹. As with many things in the last year the price movements on the markets have started with a smaller number of investors creating some momentum which has then been greatly amplified by a number of financial instruments and practices that people don't talk about anywhere near as much (if at all). Payment For Order Flow (frequently abbreviated as PFOF) could be used by High Frequency Trading firms (and others), to amplify this momentum for their own gain. If you are interested in how the investor data is being used to make money in the markets I highly recommend reading more about those two topics.

So what happened with GameStop? It wasn't just a rabid bubble like Hertz or a spike driven by algorithmic investors reading press releases like some of the other examples. The entire situation with GameStop couldn't have happened without a significant amount of money being placed into shorting the stock. Much like the meteoric rise of Tesla (NYSE:TSLA) a very important part of the picture here is to understand the mechanics of short selling as this is a major driver of the price action.

Will GameStop go to the moon and bankrupt the hedge funds who have to cover their shorts? Nobody really knows what will happen, get some popcorn ready for the next week starting 2020 Feb 1st, big things are likely to happen in one way or another (the VIX tends to agree too). I suspect if this craziness goes on much longer the rules of the game, so to speak, will change. But that's a topic for another blog post. If you already know how short selling works you might want to skip the rest of this article since this is an introduction to the topic.

How a short sale works

Short selling a stock gives you a mechanism to profit from the price of a stock declining. Short selling stocks is a rather radical concept¹ that has been around long enough for people to start to take it for granted.

The mechanism that allows short selling to work is effectively a contract that involves a loan of a stock.

Let's say there's a company, for the sake of this article we will call them ExampleStop that has shares listed on an exchange of some sort.

Now let's say we have a few people who hold this stock, Alice currently holds some stock in ExampleStop and Bob thinks that the price is going to go down.

If Bob wants to short the stock what he will do is loan the shares of ExampleStop from Alice with a contract to return those shares to Alice later. Bob will then immediately sell the shares of ExampleStop that he just received in the loan with the plan of then buying those shares back later via purchasing them from the open market. When Bob buys the shares back that is the process of covering a short position. Basically the play here is that you take a loan of the shares then immediately sell those shares with the plan to reacquire the shares at a later date at a lower price to profit from the difference at the time you have to return them.

For example let's say that the current price of ExampleStop is $10, here's how a short selling situation might go:

1. Alice loans the shares to Bob
2. Bob immediately sells the shares, Bob now has $10 from selling the share but now holds no ExampleStop shares
3. Some time passes and ExampleStop shares go down to $5
4. Bob then buys back the share for $5 to return to Alice. Alice now has the share again and Bob has $5 in profits.

You might be asking "why would Alice loan the shares to Bob if Alice thinks the share price is going to go up"? Basically in order for Alice to have any incentive to loan out the share's there has to be some incentive, as a general idea it helps to think about these trades from the perspective of all the parties as a lot of things become immediately obvious when you consider the incentives from the perspective of those involved. One way to do this is to charge interest on the loan of the stock, much like other loans, this means that Bob will have to pay interest to Alice for the ability to loan those shares. This is the cost of carrying the short. So from Alice's point of view to offer up the share to those who want to short it the interest rate has to be high enough to make this attractive, after all Alice thinks the stock is going up so loaning out the shares has to be recompensed for the transaction to occur.

(Note: There's other ways in which a transaction could be carried out as well that would provide incentives for Alice to loan a share to Bob, but these contracts be better characterized by different names.)

Short squeezes

Now what if the price actually goes up? In this case Bob still has an obligation to return the shares to Alice, this means that buying the shares on the open market if they are now a higher price than the short position will mean Bob loses money. It also means that the shares have to be purchased from whatever is available on the open market at that point in time.

If a lot of people have short positions on a particular stock a situation can arise where short sellers covering their stock end up having to purchase stock from the market which has the effect of pushing the price of the stock up. When a sufficiently large number of short sellers have to cover their positions they can actually drive the price up in the process of purchasing the shares back, which can then set up a feedback loop where other short sellers have to purchase the stock back at higher prices and so on. When this feedback loop of short sellers covering their shorts starts to push the prices of the stock up we have what's known as a short squeeze.

So going back to the example from before let's say that we have some people who have different price points at which they have to exit the short sale. Bob, Charlie and Dianna now all want to short the stock but have different limits at which they have to exit their positions.

Let's say Bob will sell at $12 to cap losses, Charlie at $13 and Dianna at $14. The following chain of events can happen:

1. Alice loans the shares to Bob, Charlie and Dianna.
2. Some time passes and good news about ExampleStop pushes the share price to $12.
3. Bob now has to exit the short position and buys a share on the open market to return to Alice which pushes the share price to $13
4. Charlie now has to exit the short position and buys a share on the open market to return to Alice which pushes the share price to $14
5. Dianna now has to exit the short position and buys a share on the open market to return to Alice which pushes the share price to $15

As you can see in this chain of events some new information in the form of the news pushes the share price from $10 to $12 but from $12 to $15 is entirely driven by a chain reaction of short sellers having to exit their positions. This example is a classic short squeeze. The actions from step 3 onwards aren't exactly a bubble or some sort of "irrational exuberance" on the part of the market, it's just a consequence of the short sellers having to close their positions impacting the price of the underlying shares which then triggers an avalanche of more of the same.

What happened with GameStop?

If you've been following the markets closely you'll have noticed the price of GameStop has gone up dramatically recently, as shown in this chart:

As you can see that earlier in January 2021 the price of the stock was under $20 and now it's rapidly spiked up to many multiples of this despite there not being any news from the company itself. A huge part of this move has been because of a massive short squeeze.

The reason a lot of this move started happening is because the short interest got to be above 100% of the available shares. Obviously this creates a situation where if the short sellers have to cover their positions they will not have the liquidity available to actually purchase back the shares to do so. Essentially more shares have been shorted than there is an ability to buy back at cheap prices. This means that any short sellers who need to cover their positions is having to pay a lot more to get the shares to cover their positions. This is causing enormous losses to the hedge funds who were short the company.

In the interim a large cult like following has started piling in to this trade just to bring the pain to the short sellers. This has been especially apparent of at Reddit on a board called WallStreetBets where a huge number of people have become interested in the story that is developing. This entire battle is mostly about a group of investors facing off against some hedge funds who have large short positions on GameStop. It's far more about this dynamic than anything to do with any of the business fundamentals of GameStop itself.

Perhaps one of the most interesting aspects of this is that a lot of cultural material is coming out of this, this goes far beyond the usual meme generation (although some of the GameStop stuff has been hilarious) and into something a lot bigger. This is turning into an interesting example of how market manipulation works and is bringing a area usually carefully confined in the shadows out into the public discussion. Faced with obvious market interference a lot of people like the popular Barstool sports guy aren't happy with what they are seeing. I was asked an especially interesting question when meeting a friend for a cup of tea the other day, she asked if there will be second order effects of this, and it seems like there will be. Perhaps that can be a topic of another post.

How is short selling different from options?

Short sales are fundamentally different from call and put options. Those options are a contract that gives the holder the ability to buy or sell a stock at a predefined price at some point in the future. No shares change hands with an option before the point in time at which the option is executed. Shares change hands in a short sale at the time the short is created and at the time the short position is covered. A crucial thing to note is that buying a put option can be a way to speculate on a bearish position on a stock but unlike going short the losses for a put option are capped at whatever the size of the option contract was. In contrast when going short losses can be infinite (or in practice this means liquidations and bankruptcy³).

People may purchase options as a way to hedge their risks from short positions, but there's nothing that fundamentally forces people to combine these strategies even if this is a relatively common practice.