Investors who buy a stock are said to have “gone long” that stock. If I buy 100 shares of Apple, I’m “long” 100 Apple, expecting that the price will rise. There’s another way to try to make money called “being short” a stock. Here, I borrow 100 shares of Apple to sell, believing the price will fall, and I can pay back my borrowed stock at cheaper prices. I’m “short 100 Apple,” and have to “cover my short” at some point in the future, meaning I’ll need to buy 100 Apple.
Here’s where it gets interesting….
If I’m short a stock and the price of that stock starts to move up, I will probably buy the stock at these higher prices to minimize my losses (remember that being short a stock means you make money only when the price falls). If many investors are short the same stock, they will buy that stock even as its price shoots upward to limit their losses. This can quickly transition to a feeding frenzy for specific stocks with large short positions, as traders bid up the price higher and higher to limit their losses, what is referred to as a “short squeeze.”
The scary part is these losses have no limit. If you buy a stock, your downside is limited to that initial capital investment as once the stock goes to $0, you can’t lose anymore. If you short a stock, it can, in theory, appreciate indefinitely and your losses can be astronomical.
Short interest in a stock is easily accessed, so traders know which companies’ shares have heavy short interest. This is what has been going on with a few select names like GameStop, AMC and even Tootsie Roll of late. Buyers of these stocks have driven their prices dramatically higher. As each of these names had large short positions, they needed to be closed out as the share prices started to rise to limit short seller losses.
The process of shorting is an important part of the price discovery mechanism. But what is going on with these select names is pure speculation and could cause damage if investors lose confidence in the markets. A properly functioning capital market system requires investor confidence that the system works for everyone. As an asset class, stocks have risen for decades because fundamentals matter. This GameStop moment, while capturing the broad public’s attention today, in years to come will likely be as memorable as the pets.com sock puppet of 1999.