I could not talk about markets without commenting on the price action in GameStop stock which has been capturing a lot of headlines.
Shorting may seem like a newfangled Wall Street invention, but investors have been betting on the price of some stocks to go down for as long as they've been looking for prices of others to go up. Although short sellers are unpopular (after all, what kind of person wants a stock to lose value?) they provide a valuable service to the markets as a whole. For example, it was noted short seller Jim Chanos who exposed outright fraud in Enron back in 2000.
The mechanics of shorting a stock are straightforward, but there is an additional step. If you sell something you don't own, you still have to deliver it to the buyer. So before hitting the sell button, you have to find someone who owns the stock that will lend it to you (for a fee). If the stock goes down as the seller hopes, they can buy it back at a lower price than they sold it, and return the borrowed shares.
Even though shorting stocks can be profitable, is is inherently extremely risky for a simple reason. If you buy a stock and it goes to $0, all you can lose is your initial investment. There is a floor underneath you. For a short seller however, there is no ceiling. If you sell a stock and the price goes up, there is no limit to where the price can go. You can actually lose multiples of your original investment.
How many shares of a company have been sold short is public information. You can look up a stock at any time and see it. (It's not just companies, but funds as well. For instance, right now the short interest of the S&P 500 is 18 percent). If the shorts become to big it could trigger a short squeeze. For instance if all of a sudden something brightens the company's prospects and all the short sellers are forced to buy at the same time. Below is a twenty year chart of Volkswagen. See if you can spot the short squeeze that briefly made it the most valuable company in the world.
What is unique about the GameStop squeeze is that it wasn't any dramatic change in their prospects. Everyone believes it will go the way of Blockbuster, made obsolete by the migration of games and video to online platforms. The belief is so strong that more and more investors sold the stock until the shorts eventually went over 100 percent. There were more shorts in the stock than the number of shares outstanding. And someone on a Reddit investor blog saw it, posted about it, and with the speed at which information is disseminated today, mobilized thousands of investors to buy the stock all at once.
One of the reasons for this story getting so much traction is because it has a David v Goliath feel to it. It was hedge funds and institutional investors getting squeezed by the little guys rather than the other way around. I don't think it is the beginning of any kind of trend however. It was a perfect setup, and I doubt there will be as much complacently by short sellers in the future as there was with GameStop.