Reddit, Gamestop and the principles of Shorting…

There has been a lot of press coverage over recent global market movements and how these tie into a platform called Reddit and transactions like shorting stocks.

 

So what does this all mean?

Reddit is a social media page. Users can post content like links, texts and images which are then liked or disliked by other members. Reddit users posted content showing how hedge funds had shorted stocks in a company called GameStop in the US and that this accounted for more than 100% of the GameStop shares.

Reddit users highlighted the risky position hedge funds had taken in shorting the stocks and so far, have been able to exploit this by telling Reddit members to buy the GameStop stocks. This large, concentrated purchase of GameStop shares pushed the price up as much as 700% in a week!

 

What is a short position and how do you do it? 

A short position on a stock is essentially a way of making money if the share price falls. Lots of hedge funds and ordinary funds use short positions to diversify and manage risks. For example, during the credit crunch fund managers were able to short banks and so make money off the back of falling share prices.

Too short a stock you find a company you think is going to struggle. A good example could be airlines during 2020 when the pandemic began.

You borrow the stock of the company from another holder, which is likely to be an investment bank. You immediately sell those shares and wait for the share price to fall. When the share price has fallen you can buy back the stock at a lower price. You return the shares to the person/institution you borrowed them from, and you pocket the difference.

For example, I could borrow 100 shares of ABC plc at £1 each. I sell those shares and so have £100. When ABC plc’s share price drops to 50p I can buy the 100 shares back and it costs me £50. I give the 100 ABC plc shares back to the original holder and I am left with £50 in my pocket.

 

So why does this affect markets?

The key thing to understand with shorting is that when you borrow the stocks you have to pay the original holder a retainer. Very similar to when you borrow money from a bank, and you have to pay them each month an amount of interest for the loan.

In short trading this is called a margin payment.

So for those fund managers shorting GameStop they have to pay a margin payment to keep their short position open – i.e. to keep borrowing the stock. When the share price of GameStop increased so to did the margin payments that fund managers had to make.

To make these increasing margin payments, fund managers have had to sell their shares in other companies and this has been on such a scale that it has pulled down share prices of the wider markets as there is an increased amount of shares being sold.

 

So what happens now?

Regulators and governments will be taking an interest into what is happening with flows of shares around the world and how much the influence Reddit could be seen to influence markets.

In the short term we are going to see volatility while markets learn how to react to varying demand in different stocks around the world. Equally the markets continue to track the development of the pandemic and how governments can vaccinate their citizens and also financially support the economy.

Volatility, whatever the cause isn’t new and it’s worth remembering that ups and downs of a market are perfectly normal. Ride out this volatility and make sure you have a diversified portfolio to spread the risk.