Introduction

Recently there has been a swirl of news related to the sudden, meteoric rise in the price of GameStop stock (as well as that of AMC and others). I have heard a lot of misunderstandings related to what occurred. Friends, family members, strangers, and people in the media, seem to harbor a variety of errors in their understanding of stock markets, “short selling”, hedge funds, and the like.

I intended to write a brief primer on some of these things in the hopes of making it clearer. However, this appears to have turned into a rather lengthy discourse on variety of subjects that the GameStop trading issue touches on. Nonetheless, I hope some will find this useful.

Note: I am not securities lawyer, nor a lawyer of any kind. I am not a broker, advisor, nor investment manager. I have no role in any investment business of any kind, other than as an individual investor who has been managing his own portfolio for 40 years. None of the information presented below is intended to be construed as investment advice. When making investment decisions, always seek advice from a qualified professional. None of the examples I provide below are intended to reflect any real-world event. I have used Apple Computer as an example to explain various transactions. This should not be construed as an endorsement of Apple, its products, or its stock. Nor was Apple Computer involved in the GameStop events in any way.

Liquidity

We refer to some assets as “liquid” and others as being “illiquid”.

For example, as of this writing, the stock of Apple Corporation is considered to be “highly liquid”. Thousands of people buy and sell millions of shares of Apple Corporation (AAPL) each day. As of this writing, the average daily volume of AAPL is almost 109 million shares! At today’s closing price of about $140/share, almost $15 billion (with a “b”) worth of Apple stock changes hands on an average day. If you wish to either by or sell shares in Apple, it will be very easy for you to do and will take just fractions of a second. There will always be someone out there that is happy to buy AAPL shares from you or sell them to you. The stock might not be trading at a price that you like, but whether you can acquire or dispose of it is not in question.

Other assets are “illiquid”. This includes all sorts of collectibles, for example “Beany Babies.” If you want to buy or sell a particular Beanie Baby, you could go on eBay and either buy or sell it there. However, it could take an unknown amount of time to either find someone selling the Beanie Baby you want or find someone willing to buy your Beanie Baby. The price to either buy or sell could vary widely depending on who the other party is, what the condition of this particular beanie baby is (which is never an issue with corporate shares), how badly you want to buy/sell the Beanie Baby, and how much the other party feels it is worth. Unlike Apple stock, there are not millions of Beanie Babies changing hands every day in a well-organized market.

Another common example is an asset like a house, which is generally considered to be “highly illiquid”. Selling a house (in the US) normally involves finding and hiring a realtor, advertising the house, making it available for inspection by interested parties, and potentially waiting while a prospective buyer arranges for a loan from a bank, has the house inspected, and so forth. Depending upon the house, the location, and the price, in the US this could take as little as a month, but it could take years or even decades. Buying a house is similarly complex and time consuming.

Why do we care about liquidity?

Well, the more liquid market is, the easier it is for individuals to buy and sell in that market. If you’re an investor, you probably like securities and commodities markets due to the liquidity. If you have money to invest, you “go to the market” and purchase whatever investments you like. If you no longer want a given investment, you go back to the market and sell it. Buying and selling are normally almost instantaneous for commonly traded stocks. [Side note: there are “thinly traded” stocks in which there are relatively few trades per day, but even in this case, there will usually be thousands of shares changing hands on an ordinary day.]

You might like investing in art, or collectibles, or real estate; but in doing so you must understand that you may or may not be able to get into or out of an investment when you want to, or you may have to take a significant loss in order to get out of such an investment in a hurry. Because of illiquidity, you’re probably not going to be willing to invest unless you’re quite sure that there are significant gains to be made.

Buying “on margin”

Stated simply, buying stock on margin is purchasing stock using money that a broker lends to you for that purpose.

Imagine that you think Apple stock is going to do very well in the future. So, you use the money that you have for investing to buy shares in Apple. This is a very normal transaction that happens every day. If the stock goes up in value, great, you make money. If it goes down, you lose money. Very straight forward.

Now let’s say that you really, really think that Apple is going to do super well in the future. You might wish that you could buy even more shares than you can afford. You might be able to borrow money from friends, relatives, or a bank, and use that to buy the stock. Alternatively, you could borrow the money from a broker to buy more shares, “on margin”. If you’re right and Apple goes up, then you will have made even more money than had you simply purchasing the stock outright, because you own more shares than you were otherwise able to afford. On the other hand, if you’re wrong and Apple goes down, you will own more shares that have lost value. You will have lost more money than if you hadn’t borrowed to buy those extra shares. Also, no matter what happens, you still owe the broker the money that you borrowed. Sooner or later you’re going to have to pay up. Buying shares on margin multiplies the amount you could gain, and the amount you could lose. This is a form of “leveraged investing.”

If you ask friends or family to lend you money, they might just give it to you (sweet), but if you ask the broker to buy you Apple on margin, they are going to want collateral on the deal. In this case, the collateral is simply the stock itself. But stocks go up and they go down, and if your investment goes down, then you might no longer have sufficient collateral to cover the loan.

Let say you bought $10,000 of AAPL on margin. If your stock were to lose $1000, then there would be only $9000 worth of Apple in the account. Now your $10,000 loan is collateralized by just $9000 worth of stock. To make sure that there is always enough collateral in the account to cover your loan, brokers have what’s called an “margin requirement”. This is an amount of money that they insist you have in your account so that there is enough collateral to cover the loan even if the stock goes down in value. For example, let’s say the margin requirement is 20%. To buy that $10,000 worth of Apple, the broker is going to insist that there is at least $2000 in your account (in addition to the $10,000 worth stock.) If Apple stock goes up, good for you. Everything is just peachy. However, if Apple were to decline, the total value of the account will go down. If you then skip town, the broker could be left holding the bag, but, because of the margin requirement, they can still make themselves whole by selling the stock and making up any loss from the cash you provided as collateral.

Under normal circumstances that is not the conclusion anyone wants. You want to keep the investment, and the broker does too. But there is no longer enough value in the account to cover the 20% margin requirement. The broker wants to maintain the account with total assets worth at least the value of original investment plus a 20% buffer. With the stock worth less than its original cost, you are going to have to kitty up some more dough.

The broker is going to make what is called an “margin call”. Basically, they’re going to call you up and say, “hey, you gotta put more money in the account.” If you don’t, they will sell enough of your shares of Apple to bring up the amount of cash in the account, and lower the number of shares, thus covering the exposure. This is part of the margin loan deal. The broker can sell your shares if they feel they need to. [Note that the margin amount in your account does not need to be in cash, it could be shares of some other stock. However, if that is the case, should that other stock go down, that too might trigger a margin call if there is then not enough total value in the account to cover the margin requirement.]

Finally, the broker didn’t just lend you that money out of the goodness of their heart; they are going to charge you interest on the amount loaned for the entire period that you borrowed it. So, your chosen stock needs to go up by at least enough to cover the interest on the loan, and you want it to do so pronto.

Going “long”

When someone owns shares of a stock (or some other investments) we will often say that they are “long” that stock, for example, “I am long Apple.” Similarly, if someone owns a lot of shares in different high-tech stocks, we might say that they are, “long high-tech”.

For the purposes of this discussion, “long” is really only interesting in that it is the opposite of “short”.

“Short” Selling

Short selling (or “selling short”, “going short”, or “shorting”) is the crux of what was going on with GameStop recently.

Simply stated, a “short” is selling something that you don’t own – in this case, shares of a stock. A broker will lend you the stock so that you can sell it. You might want to do this if you believe that the stock is going to go down in value over time, just as you would go long if you thought the stock was going up. You borrow the stock today at its current market value and sell it at the going price. Later you buy that stock back at the then current market price and return it to the broker. Assuming the stock did go down over that period, you keep the difference between what the stock was worth when you borrowed and sold it, and what it was worth when you repurchased and returned it. Of course, if the stock went up instead, you’re going to have to rebuy it at a higher price than when you borrowed it, so you lose the difference.

Note, that this is effectively borrowing from the broker, and so it is a transaction on margin. You will have to pay interest on the transaction, there will be a margin requirement, and you may be subject to margin calls. The only difference is that in this case you would face a margin call if the stock went up (making your short position worth less) rather than getting a margin call when the value of the security goes down, as is the case in a normal purchase on margin.

Limited gains but unlimited losses are possible

One important thing to be aware of with short selling is that there is a limit to how much profit you can make, but your potential loss is theoretically limitless.

For example, let’s say you buy (long) a stock at $20 a share. The most you can lose is $20 a share if it were to go to zero. On the other hand, it could be the next Google and just rise and rise and rise making you more and more profit. However, if you sell that same stock short at $20 a share, the most you can possibly make is $20 - if the business goes bust. However, if you were dead wrong, and the stock shoots up, you are losing money all the way up. In practice, stocks don’t go from $20-$1 million over night, so practically speaking, you can’t actually lose an infinite amount of money, but depending upon how many shares you have shorted, you can lose a hell of a lot more than you can gain, and theoretically your potential loss is unlimited. Sophisticated investors are supposed to understand this risk.

Is short selling legal, and why does it exist?

Short selling is entirely legal. It is a common practice. I have done it myself.

Why is there this thing called short selling, and why is it legal? Basically, it helps increase liquidity in the market overall. The more buying and selling of stocks, the greater the market liquidity. By allowing people to borrow stock that they don’t own and then sell it, you have increased the number of transactions, and the number of people buying and selling stock. Since liquidity is good, the availability of short transactions is good for the market.

Also, prohibiting short selling would be almost impossible. The SEC could prohibit brokers from lending shares to investors, but it would be very difficult to prohibit individuals (or firms that aren’t brokers) from lending stock to each other and then selling it.

We should also note that it is usually wealthy individuals who do things like this. Not because poor people are actively excluded from these markets, but because poor people don’t normally have the money available make such risky investments - if they can afford to invest at all. They might also have poor credit, in which case the broker would not be willing to lend to them for any margin activity, be it long or short.

Hedging

Hedging is basically “hedging your bets”. Hedges are simply ways of insuring your portfolio. You buy a stock or other investment that you expect to go up, and then you also by something else that will go up if that first thing goes down – i.e., you buy two investments that move opposite to each other. Most of this requires sophisticated analyses. Hedging in a portfolio is a way to reduce risk at the cost of purchasing the hedge. Though it reduces the possible total gain of the portfolio, it reduces the amount of money that can be lost.

Effectively, hedging, it is a fancy kind of insurance. People buy insurance all the time to hedge various risks. You use your life savings to buy a house. That is a major “investment” for you. But all kinds of things could go wrong that would wipe you out: fire, flood, Godzilla, etc. So, you buy insurance to cover your loss if something happens to your house. This is the same thing as buying a hedge on your portfolio. If your investment goes down, your hedge goes up, reducing or eliminating the loss. Hedges cost money (and hence lower your return in the case where things go well), but they reduce risk. Making money with as little risk as possible is the name of the game.

Hedge funds

Originally hedge funds were basically managed portfolios in which the hedge fund manager and his or her team used all kinds of fancy esoteric methods to make money regardless of whether the economy went up or down, the stock market went up or down, etc. They promised to use hedging to make money with as little risk as possible. Some hedges sound crazy (to me), but apparently the math works out (usually.)

Over time, the hedge fund world changed. A lot of funds gave up on the idea of low risk, and instead used their sophisticated investing techniques to take big risks in the hopes of extraordinary gains. Bernie Madoff’s fund (which turned out to be a hoax) was pretending to be just that. It was actually a Ponzi scheme, but it seemed to investors at the time as though Madoff was successfully taking big risks and returning outstanding results. There are still hedge funds whose business is making money with as little risk as possible. But there are also now funds which call themselves "hedge funds", courting investors by chasing extraordinary gains.

Most hedge funds specialize in some particular strategy. One of the original types of hedge funds is referred to as “long-short equity”. Such a fund buys one investment (“going long”), and shorts some other investment, so that no matter what happens they make at least a little bit of money on the deal, and if they did it right, the risk was negligible.

However, nothing is ever certain. You can never eliminate all risk and still make any returns. During the great recession of 2007-2008, markets were roiled by a “once in a century” shakeup and a tremendous (temporary) loss of liquidity. Facing margin calls, hedge funds (and others) were forced to get out of positions at a time when no one was buying, and so had to sell at “pennies on the dollar.” During that period, long/short hedge funds lost prodigious amounts of money, in spite of having their positions carefully hedged. They hedged against a normal market environment. They did not hedge against markets collapsing as they did in 2007. In a similar way, funds that were recently shorting GameStop were not hedged against the possibility of the stock shooting up with no one willing to sell them the stock they needed to close out their short positions.

Another type of hedge fund is a “distressed” fund. These funds look for opportunities in businesses, real estate, or other investments which are in trouble - investments which are “distressed.” They then attempt to make money either by short selling the investment or buying the investment and attempting to increase its value (possibly by breaking it up and selling the parts ala “corporate raiders”), or by bringing in new management for the business, or by putting together a group of investors that will buy the business and attempt to turn it around, or other things. [Side note: the 2007-2008 recession created lots of opportunities for distressed investing. However, there was so little liquidity in the market that many funds weren’t able to take advantage of these opportunities.]

There are lots of other kinds of hedge funds, but these are the two types that are interesting for our story.

Are hedge funds only for the rich?

A complaint that people tend to have about hedge funds is that they are only for the rich. That the game is rigged for the wealthy, and the little guy can never get ahead. It is true that small investors generally cannot invest in a hedge fund, but not for the reasons most people think. It’s not some rich guy club that is out to screw the poor and won’t let less affluent people in.

There are two main reasons why only wealthy individuals can invest in hedge funds.

First, these are odd, esoteric, investments with specialized risks. So, hedge funds will only accept investments from experienced investors. This is to keep novices from investing in products where they might not understand the risks that they are taking. “Shares” in a hedge fund are private sales to sophisticated investors and are largely unregulated. People who cannot afford to lose large amounts of money should not be in this arena, even if it can offer great rewards. So, hedge funds will not accept investments from inexperienced investors who cannot afford big losses if things go wrong.

Second, these sophisticated mechanisms often require long timelines to execute. If you’re going to buy real estate in Tokyo and hedge it against Argentinian cattle (hyperbolic example), that’s a very illiquid set of trades. For this reason, hedge funds often limit the timing or frequency with which you can extract your money. They may allow investors to withdraw money only once per year, or only on one particular day in the year, or even less often than that. So, they want to make sure that the partners (their investors) have sufficient personal funds to put in huge amounts of money, and not take it out for a very long time. Having lots of small investments from people with limited net worth, that might want to remove their money at any time, would make it impossible for a hedge fund to successfully execute its strategies.

Fiduciary duty

Another thing that’s important to understand is fiduciary duty. “A fiduciary duty is an obligation to act in the best interest of another party.” (definitions.uslegal.com) Hedge fund managers, as well as other investment advisors, are required to act in their clients' interest. It is illegal for them to do things which are not expected to benefit the client. So, when people point at hedge fund managers and accuse them of being greedy, their actions aren’t entirely driven by greed. If they see a market opportunity that fits their mission, they are obligated to invest if such an investment is in the best interest of the hedge fund and therefore its clients. If they see an investment which is outside their stated mission, or is not in the fund’s best interests, then they are legally prohibited from making that investment. It is said that they have a “fiduciary duty” to their clients (which doesn’t mean that they aren’t greedy, just that in this case they are not acting on behalf of their own greed.)

Holding stock in street name

Investors virtually never take possession of the stock certificates for the shares that they own. Actually having the physical pieces of paper is kind of a pain in the ass. You’ve got to get them from your broker, store them safely, and then get them back to your broker when you want to sell. At the end of the day, you want to participate in the profits of Apple Corporation, you don’t care about that piece of paper.

So, under normal circumstances brokerages hold their client’s stocks for them “in street name”. This means that if you put in order for AAPL, the brokerage buys the shares on your behalf and just makes a note that they are yours. It’s pretty much all electronic anyway these days. You will get such privileges as receiving dividends (if any) and voting those shares at a shareholders meeting, but underneath the covers it’s all done with smoke and mirrors.

One aspect of the GameStop fiasco is that many of the people involved didn’t understand how it was that brokers could just lend somebody’s stock to someone else. Basically, the stock was held in “street name”, not owned by the individual investor. So, the broker could lend it to someone else without so much as a by-your-leave from the investor.

Just as with the EULA’s (End User License Agreements) that people sign all the time without reading them, this information is spelled out in the contracts people sign with their brokers (and probably don't read). Most people never need to know this stuff - it hardly ever matters. But these facts managed to ruffle a lot of feathers of people who didn’t realize them during this GameStop business.

So, what the hell happened with GameStop?

Well, some managers at hedge funds, as well as sophisticated individual investors, saw GameStop as a distressed business, and therefore an opportunity. These investors saw in GameStop what they had seen in Blockbuster Video years before. People used to go to Blockbuster to rent videotapes or DVDs. But along came Netflix, first allowing customers to rent and return movies through the mail, and then online. Then Walmart jumped into the act, and Amazon, and others. Blockbuster was late to the online game so didn’t survive.

GameStop is a bricks and mortar store that sells video games. But nowadays most gamers play online or buy and download games over the Internet. GameStop’s business is drying up. When COVID-19 came along, people stopped leaving their homes at all, let alone going to a store to get something that they could get more easily, safely, and conveniently online.

GameStop’s business is a bad business to be in right now. They are selling buggy whips in the age of the automobile. Investors observed this, predicted its stock would go down (eventually to zero), and so sold the stock short. But, surprise, surprise, a group of young people figured out a way to outsmart the short sellers. They realize that there were so many short-sellers that if they bought enough stock to drive the price up just a little bit, margin calls would force covering of shorts making the stock price go up further, which would force more margin calls, causing it to spiral upwards, costing the short-sellers vast amounts of money. It is uncommon that a stock is so highly oversold, with so much leverage, that a small amount of buying would generate such a large and rapid reaction in the market. Well, now we know. Ooops.

Were laws broken?

As noted, I am not a securities lawyer. Indeed, I’m not a lawyer of any kind. But I am certain that the hedge funds and brokers (including Robin Hood), are run amok with lawyers. These entities might very well get as close to the line of legality as they possibly can, but their lawyers should make damn sure that they don’t step over it, especially once the eyes of the world were focused on them, as they were once GameStop blew up in the news. Thus, I would be surprised if any of these entities broke any laws or regulations.

On the other hand, the individual investors trading in GameStop, not having the benefit of staffs of lawyers, may have broken laws, intentionally, by accident, or due to a lack of understanding of how the laws are applied. Of that I cannot say.

Should any laws or regulations be changed because of these events?

Honestly, I don’t know. But I suspect not. The hedge funds that lost money knew what they were doing. They are highly sophisticated investors. They knew the risks they were taking, even though in this case it turns out that they underestimated those risks. It’s hard to blame them though, because nothing quite like this ever happened before, so these events weren’t in their models.

The investors in the hedge funds, and other investors that got hurt in the short selling, should have been sophisticated investors. Brokerage houses should have been making sure that novice investors weren’t buying shorts.

Those investors from the Reddit board observed a market opportunity and took it. They were not working based on secret insider information. They did not break into systems, or hack something, or steal money. Everything they did, they did out loud, in the open, on public bulletin boards, using publicly available information. Clever. Not illegal.

Should laws and regulations be changed to better protect innocent investors, or protect the proper operations of the markets as a whole? Again, I don’t know, but I suspect that no changes are required. Sophisticated investors who practice these strategies are now warned that there are really clever people out there that might very well exploit any error they make. These sophisticated investors should carefully review their investment practices to make sure that there are no other such errors in their portfolios. But that doesn’t mean we need to create a new law requiring them to do so.

Conclusion

Hopefully, this post will help people understand what happened, what these investment mechanisms are, why they exist, and how a group of individual investors on Reddit managed to shoot gaping holes in the portfolios of a group of hedge funds. I hope this will help people understand that, though we do have terrible wealth disparity in this country, this particular event does not expose a world of nefarious wealthy investors taking advantage of their wealth to collude with other greedy, rich, old men (and women.)

Wealth disparity is a crushing problem which is destroying the fabric of our society and our economy. But it should be cured by increasing taxes on people like me, and breaking down systemic racism and the barriers that limit what people of lesser means can achieve in their lives. Opportunities should be increased. School systems should be improved. College should be made affordable. And so on. Ending a handful of investment mechanisms such as short selling and hedging won’t solve any of these problems.