This article is part two of a three-part series on the current GameStop saga. The first article “GameStop and the Short Squeeze” can be found here. Today we’re talking about short selling and its role in a healthy market.

Remember those Merrill Lynch commercials from years ago that said, “We’re Optimistic about America”? It’s a great feeling, but inviting everyone to be bullish is actually not good for the markets. If everyone leans bullish (or bearish) the boat can tip over. That’s why we need short sellers.

What is short selling?

It’s just about the other side of a bullish trade. Instead of betting that the price will go up, the price will go down.

Here’s how it works: a trader borrows a stock, sells it, and then buys it back to return to the lender. The trader does this because he thinks the price or valuation is too high. They patiently wait for the stock to fall, and when it does, the short seller will “cover” their position at a lower price. The difference is a win for the short seller.

There are numerous reasons for short sellers to take a short position, but valuation is certainly a good one. This is what happened to GameStop. The retailer is threatened with extinction thanks to online gaming (and their inability to respond). Fund managers believed that GameStop would eventually tip over and die, so they took short positions. Melvin Capital Management had a massive short position which is why the name hit the news.

The only caveat to selling short is that if the stock rises above your capital requirements, you will eventually have to “cover” your position, otherwise known as buying back the stock. You bet it will be at a lower price, but it could be at a higher price. The buyback can result in more buyers picking up the stock, undoing the short seller’s position.

This is what happened to GameStop. Traders who followed Wallstreetbets on Reddit piled in the stock and increased demand. Prices rose – and they continued to rise through January. Melvin Capital and other short sellers never dreamed GameStop would rise like this in a million years. But that’s the other side of the trade. When someone is long, someone is short. It’s a zero sum game.

Selling stocks short is not a “bad” activity

The authorities are investigating the GameStop saga, which makes it appear that short selling is “bad”. It is not. Short sellers offer a good balance to the market as the markets are known to not rise directly every day. If there were no short sellers in the markets and all stocks were long, the markets could potentially collapse far more frequently.

Next week is the final part of this three-part series. We’re going to talk about risk management

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