• Friday, July 19, 2024
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Short selling: An Explainer

Investment ready companies must have these fundamentals in place to attract investors

The business world was taken by storm when a group of amateur investors joined forces on short sellers, sending the share prices of some undervalued companies surging, causing painful losses on the short sellers who bet against them.

This is one of the biggest stock market stories in 2021 so far. GameStop, a video game retailer has seen its stock price rising far beyond what most people perceive it is worth and they have some short sellers and WallstreetBets group to thank for that.

What is short selling?

Short selling is a way an investor makes money by betting that a company’s share price will fall.

This means an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender.

In stock trading, the traditional way to make is to buy low and sell high but when short selling the reverse is the case as the investor borrows a share from a broker, sells and hopes that profit can be made by buying back the share at a lower price.

Let’s take for instance, a company ABC has a share price of N20. If an investor takes a bet that the share price would fall, the investor can borrow 1 share and sell it immediately at N20. At this point the investor has N20 while owing the 1 share he borrowed.

If Company ABC share price does indeed drop amid pessimism around the company, with the N20 shares now worth only N10.

The short seller buys back the shares for N10 less than it was sold for. They return the borrowed share and make a profit of N10.

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Short selling can go wrong

Short selling does not always go right and this can result in losses for the investor.

In any case, the investor’s prediction is incorrect and the shares of ABC appreciates instead to N25. This might signal trouble as the investor would still need to return the 1 borrowed share.

This means it is going to cost a lot more to buy it back. If the short seller buys it back at N25, a loss of N5 will be made.

The more the price rises, the bigger the short seller’s loss.

This was what happened the GameStop, the short sellers bet went south

What happened to GameStop?

Melvin Capital, a major hedge fund spotted GameStop, a company already on the verge of bankruptcy and decided to short sell to make some quick profit as shares were bound to fall.

GameStop revenue has fallen in recent years as more people download games rather than buy them in stores.

This was when a group of amateur stock traders on Reddit, a social news platform decided to crash Melvin Capital’s party.

The investors who call themselves WallstreetBets began to buy GameStop shares, piling money in and shares began to rise around 200 percent from December.

Acting in unison they pushed up the share price to astronomical levels causing massive losses for short-sellers.

GameStop shares ended the year 2020 at $18.84. The stock traded above $482 during the week and plunged 44 percent at $193.60, Thursday.

How can a small group of Reddit users afford the buying spree?

Asides buying shares, they were using call options. Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. These are the right to buy shares at a certain price and they effectively function as a leveraged bet, a purchase that only requires you to pay a fraction of the share price. This is the fuel that stokes the short-squeeze fire.

What will happen to the market after this?

It is not rare to see investors clash from having different perceptions of a company’s value but it is not usual to see ordinary investors causing a large fund such heavy losses.

GameStop’s dramatic turnaround story indicates that power the internet can have and it may cause short-sellers to think again about betting against a company they think its shares will fall.

That may serve as a check or balance on other large forces such as hedge funds, which are used to throwing their weight around without ordinary investors affecting a price.