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When Shorting Stocks goes All Wrong

Written by Briton Ryle
Posted January 27, 2021

That a pure democracy if it were practicable would be the most perfect government. Experience has proved that no position is more false than this. The ancient democracies in which the people themselves deliberated never possessed one good feature of government. Their very character was tyranny; their figure, deformity.

— Alexander Hamilton, 1788

The FBI is knocking on doors, identifying the treasonous with screenshots of Facebook posts.

I feel kind of bad for them in a "thief leaves wallet at crime scene" kind of way. It's all fun and games as you gripe about a government out of control with your 148 friends on the interwebs. And I'm sure it was pretty exhilarating, walking into that marvelous building with all your Twitter pals like you've really accomplished something — you're gonna fix all that's wrong with America!

It's probably kind of a sinking feeling when the black SUVs pull up at your house. 

Nobody ever stops to think, "OK, you've taken over a government. Now, what are you gonna do with it?" It's not like bringing a stray puppy home. You can't call customer service: "Hello? Is this the returns department? I'd like to return this government; it's really more than I can handle. Maybe I can exchange it for a nice jet ski?"

The truth is that nobody really wants to take over the government. Maybe I'm naive, but that's how I see it. What I see play out on Twitter and Facebook is mostly just a popularity contest. Who has the most misfortune? Who has the most insight? Who can post the most relevant GIF?  

There's a reason that "belonging" comes right after food/shelter and safety in the hierarchy of needs pyramid. We are social animals and we need to have our knitting circles and poker buddies and take over the government groups.

Anyway...

My point here isn't about right and wrong. There are obviously important things that won't be resolved here in an article and upon which my input is not really significant. My point is about the power of social media. And yes, there is a very relevant angle for social media and investing.  

#GAMESTONK

Tesla founder and richest man in the world Elon Musk tweeted #GAMESTONK the other night. You might not get the reference, but that one-word tweet was enough to send shares of slow-motion-disaster stock GameStop (NYSE: GME) up 137% to $334 a share. 

Now, "stonk" is like a dufus way to say "stocks" because buying and selling stocks is kind of a lowest-common-denominator investment. It doesn't require any level of sophistication, unlike real estate, or bonds, or futures. Anybody with a few extra bucks can get a Robinhood account and start trading stonks. 

GameStop started out as a used video game store. It'd buy your video game discs for $5 and resell them for $40 or $50 bucks. It was a relevant business model 15 years ago when video games were actually on discs. Today, video games are all in the "cloud." You buy a subscription and you play the games. There's no actual ownership of the game anymore, so there's no secondary market for the games. As you might expect, that transition from disc to the cloud hasn't been especially helpful for GameStop's business model. But ironically, it's been an incredible catalyst for the stock (or "stonk" as is absolutely the case here) because somewhere along the line, the unsophisticated are gonna lose money. 

GameStop has teetered on the brink of bankruptcy for years. The problems are so glaring that virtually all of the GameStop shares have been sold short. When you sell a stock short, you borrow the stock and then sell on the commitment that you buy the stock at some point to replace the shares that you borrowed. Short-selling involves margin because you have to show that you have the resources to buy the stock at a later date. The goal is to buy the shares at a lower price than the one at which you sold.

Of course, things don't always go according to plan. So if you sold $5,000 worth of shares of GameStop short, and the value of those shares goes higher to $10,000, your broker will have questions for you. Somebody's on the hook for that $5K, and it ain't your broker. Thing is: The broker doesn't actually ask. They just look at your account, and if you don't meet the margin requirement, they will very kindly start liquidating your positions for you. This is known as a margin call. They'll start with your losers and move on to your winners. 

The Sucker at the Table

Margin is a form of leverage. If you have $1,000 in stocks in your brokerage account, your broker will probably lend you $500 to buy more stocks. And in a bull market like the one we have right now, where stocks do nothing but go up, buying stocks on margin can be great. 

Of course, when stocks like GameStop are going higher, it isn't going great for the investors who have sold it short. Many of the GameStop shorts have hit their margin limits and have been forced to buy the stock at higher prices to cover their obligations. The buying pressure from shorts covering their positions is called a short squeeze, and it can result in some amazing ramp jobs.

GameStop shares closed at $150 on the 26th. The shares opened at $354 on the 27th. I guarantee you that some investors who were short GameStop had their entire accounts wiped out at the open this morning. 

So when Elon Musk tweeted #GAMESTONK, he knew what he was doing. There has been a campaign on Twitter and another social media site, Reddit, to get a short squeeze going on GameStop.

Why would the richest man in the world jump into this fray? Because he can. With one word, in one tweet, he can play puppetmaster and watch everybody dance. 

I'm sure there are some investors who have bought GameStop, thinking that they're on the right side. After all, Elon has their back. Whaddya want to bet that Elon's next tweet is #GAMEBUBBLE?

Who's the sucker in all this? I don't know. That's why I'm not at the table. 

Word to the wise: If you try to take a tweet into real-world action, the sucker might be you. 

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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