What Is Short Selling? All About The Practice That Drained A Hedge Fund

Published on January 29, 2021

If you have been paying attention to the financial markets over the past few days, you have no doubt heard a lot about Gamestop, Reddit, and short selling. The GameStop (NYSE: GME) stock exploded seemingly overnight, going from 42.59 dollars a share on Friday January 22nd to a high of 469.42 dollars a share on Thursday January 28th before Wall Street and several trading platforms, including Robinhood, intervened.

A community on the online forum Reddit called r/WallStreetBets was directly responsible for the stock’s unprecedented performance. The r/WallStreetBets Redditors came up with a plan to band together and bet against Wall Street itself. They found a list of companies that were being heavily short sold by hedge funds and decided to collectively purchase those companies’ stocks.

The effect of the action was two-fold, not only would the influx of stock purchases increase the stock price and thusly earn those Redditors money, it would cause the hedge funds involved to lose money—a lot of money—essentially siphoning cash out of Wall Street and into the pockets of millions of Americans. Experts have called it one of the most significant moments of wealth redistribution in modern history, and there are no signs that it will slow down as the retail traders and hedge funds are currently locked what can only be described as a finance war. This combination of a community banding together for their own benefit, as well as to troll the establishment, is commonplace on Reddit—but never before has it been seen to impact the nation on such a massive scale. And it all started when one hedge fund, Melvin Capital, short sold more shares of the GameStop stock than actually exist.

Short selling is a practice that Wall Street investors, hedge funds in particular, use often. What it is, in essence, is the act of borrowing the stock from companies that investors predict will continue to perform poorly before returning the stocks once the price has dropped below the value at which it was borrowed. After returning the stocks, the investors would get money from the lender to cover the difference. For shorting to work, stock in the company has to continue to go down for the hedge fund to be able to turn it for a profit. Reddit users realized that the hedge funds were relying on the failure of several beloved businesses and wanted to help the businesses, but also realized that the mistake that the hedge funds made enabled them to drain the pockets of wealthy Wall Street executives.

Once r/WallStreetBets decided to band together to bet against the hedge funds, the stock price went up. Because the entire success of a short sale hinges on the stock dropping, hedge funds were put in a precarious position because if the stock continued to rise they would owe money to the lenders when it came time to return the stocks. Not only did they have to buy back the stock that they short sold, but they had to pay for whatever the price had inflated to. Since so many Redditors were investing in the same stock, the price skyrocketed several hundred percent in a matter of hours. This lead to many hedge funds covering their bets and returning the borrowed stock by buying it back. The masssive buy back of GameStop stock caused the stock to shoot up even farther, leaving Wall Street wondering how they got beat at their own game.

The amount of money Wall Street lost on GameStop is unknown at the moment, but there are reports that Melvin Capital lost nearly $5 billion dollars. GameStop was chosen as the target by Redditors not because they like games, but because GameStop was the stock being most heavily short sold. They also enacted similar successful campaigns with AMC Theaters.

The money lost by hedge funds left Wall Street scrambling for regulation and prompted Robinhood, the online trading platform most used for the WallStreetBets campaign, to freeze purchases of GameStop and AMC stock. That freeze seemingly put an end to the rally but also has the average-citizen investor up-in-arms. Many are frustrated with the way that Wall Street and Robinhood put an end to something that was not illegal in any way, giving the hedge funds a clear advantage over retail traders.

Justin Shamlou is a Senior Staff Writer at Grit Daily. Based in Miami, he covers international news, consumer brands, tech, art/entertainment, and events. Justin started his career covering the electronic music industry, working as the Miami correspondent for Magnetic Mag and US Editor for Data Transmission.

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