I am the absolute worst gambler. Several years ago, I headed out to Las Vegas to celebrate a friend’s 30th birthday, spent a lot of time in the casinos, and very little time gambling. My friend discovered that if she was sitting in front of a slot machine, occasionally pushing the button, she got drinks for free. Sitting next to her, I benefitted from this perk. Thus, we spent a lot of the long weekend chatting and sipping on drinks, while hanging out near a slot machine. It was a lot more fun than it generally has been when I lose my money in a casino. I am sure there are may strategies and techniques that people employ when gambling, but I don’t even know the theories, so I tend to essentially throw my money at a machine or croupier and hope for the best.
When it comes to some financial terms that are being bandied about in discussions about GameStop, I can at least try to explain what the terms mean. I find that what is going on in the stock market right now involves many short words that may be more complicated than they sound. Hopefully, clarifying them will help us all get a better idea of what is going on. I am going to speak about shares (because that is what is at play with GameStop) but these financial terms apply to all kinds of securities. Securities are financial instruments that are tradable and fungible, or mutually interchangeable. The fungible characteristic is what makes securities so easily tradable. Securities being fungible means that they are for all practical purposes, considered to be identical and can be exchanged for one another. You can exchange one $20 bill for two $10 bills. In contrast, though they are both seats one does not consider a front row seat to be the same as a back row seat, especially if everyone in front of you is way taller, so these seats are non-fungible.
I shall start out by talking about buying on margin. In the stock market, when you buy on margin, it means that you are buying securities using only a percentage of your own money. For example, say you want to buy a share for $100 but only have $10 to your name. You approach your local broker and that broker agrees to lend you $90 to get you to the $100 to buy that share. Because just about nothing in life is free, the broker charges you 10% interest on the $90. In a year, you decide to sell that share. When you do that, you will need to repay the broker $90 plus $9 in interest. If you skipped over those sentences because you saw numbers and didn’t want to to math, buying on margin means you only need to use a fraction of the money needed to buy shares and you can borrow the rest, paying interest. If you are able to sell the shares for more than what you paid to buy it, that’s great. You can use your profit to pay back your loan (plus interest) and happily take the rest home with you to do with as you please. However, if the price of the shares goes down, you will lose your money and may have to find money elsewhere to repay your loan. In the United States, the Financial Industry Regulatory Authority (FINRA) generally requires that a customer use 50% of their own money for their first time or initial purchase of securities. People who want to short sell securities, also need margin accounts.
For all the people who are optimistic about share prices and financial markets, there are those who look at securities and believe that the value of the securities will go down. Some may call these people pessimists, and these people may call themselves realists. Po-tay-to or Po-tah-to, these folks seek to benefit from their price downturn point of view by doing what is called short selling (or shorting) the security, and this is how shorting works. Pessireal (as we shall call them) goes to their broker and says, “I would like to borrow one $100 share of Tulip stock. Everyone is all about Tulip these days, but I just don’t see that ending well.” The broker will then sell a $100 share of Tulip stock, and give the $100 to Pessireal, less any transaction fees (again, nothing for free). Pessireal will then sit back, wait, and watch the market. If Pessireal’s gut is correct about Tulip and that the value of the share goes down to $50, Pessireal will take $50 of the $100 and buy a share of Tulip stock which they will give to the broker to, as they say, close the short position. So, Pessireal is giving back the borrowed share and has made $50 (less fees) while they’re at it.
Suppose, however, that Pessireal is wrong about Tulip, it becomes the best thing since sliced bread, and nothing can keep its price down. Pessireal may realize the error of their ways and decide to cut their losses when the share price is $200. In addition to the $100 they got from their borrowed share, Pessireal will have to spend an additional $100 of their own money to buy the share they need to return to the broker. Although this is rare, sometimes it is the broker who may decide that they want their share back. It could be because the broker has been watching Tulip’s share price going up and when it gets to $300 a share, they start to fear that Pessireal won’t be able to pay them back. So they call Pessireal up and, despite’s Pessireal’s attempts to assure them that Tulip’s demise is on the horizon, they demand their share be returned. This means, whether they like it or not, Pessireal will have to find an additional $200 to bring the $100 from the borrowed share up to the $300 needed in order to buy a share of Tulip and return it to the broker.
With the regular trading of securities, the worst that can happen is that the value of your investment can go down to zero. That hurts but at least you know that the most you can lose is what you put in. The best that can happen is pretty much infinite. Your gain is whatever the price of the security goes up to be, over what you put in. Short selling is the opposite. You can calculate the most you can earn on a security – the lower the price goes, the more you make, up until the security is worthless. On the very scary flip side, the most you can lose is pretty much as high as the share price soars, which could be, as GameStop short sellers are finding out, can be pretty darn high. Brook Gladstone, the host of On The Media, shared that she spent almost $1,000 on 42 shares of GameStop stock in 1999 and by April 2020, that investment was worth $3.50 a share – $147. She sold her shares when they were at $100 a share. Most of last year, GameStop’s stock was valued at $250 million. The stock has exploded to a point where GameStop’s stock value is around $20 billion! If you are a short seller, that hurts.
The last thing I will mention here is the short squeeze. Say, Pessireal was not alone in thinking that Tulip’s share price was going to crash, and that many had decided to short Tulip but, instead, that price was soaring. Some short sellers may take a look at the soaring price and at their sources of funds and decide that they were ready to cut their losses. If there were enough of these short sellers looking to buy Tulip shares so that they could return them to their brokers, and close the short position, this higher demand could push the share price even higher. Right now, with GameStop (and other stocks) there are a lot more people looking to buy shares than are looking to sell. The trusty supply and demand chart comes in to show how the increased demand will increase the price. The short sellers, looking to cut their losses and repay their borrowed stock, are, in turn, squeezing that price up too.
I can’t say when and how this will end; I am no good at the Vegas game. Heck, I can’t even let what happened in Vegas stay there. I do, however, hope that as you read or listen to stories that are throwing out financial terms, you will nod along and think – I get it.