It is possible to make money when stock prices go down. That is the strategy of short sellers.

 

From the US Securities and Exchange Commission’s Investor.gov website: “A short sale occurs when you sell stock you do not own. Investors who sell short believe the price of the stock will fall. If the price drops, you can buy the stock at the lower price and make a profit. If the price of the stock rises and you buy it back later at the higher price, you will incur a loss.” For a short sale, the loss could theoretically be unlimited since there is no upward limit to a stock price.

This is a short-term strategy that is speculative and can be very costly if the stock rises in price.

The Short-Squeeze and Gamestop

A sharp rise in the price of a stock forces short sellers to close out their positions as they try to limit losses. The positions are closed by buying that stock at the higher price adding to the demand for the stock and pushing the stock price higher still. This effectively ‘squeezes’ the short sellers out of their positions.

Over the past week the price of Gamestop stock has risen from $19.95/share on January 12 to as high $483.00/share on January 28. This price rise was driven mostly by individual investors and caused a squeeze for several hedge funds that had leveraged short sale positions in Gamestop. The short positions equaled over 125% of the outstanding shares and as those short positions closed, the price rose very quickly and the losses added. Although the losses have not been made public, some hedge funds could have lost billions of dollars.

Is this a concern for the long-term investor?

Short answer – No.

Although widely covered by the media, this is not the first time a short squeeze has taken place. Normally it is different institutional investors or hedge funds choosing sides on whether a stock price will rise or fall. This time individual investors squared off against the hedge funds that were over-extended on their short positions and the mainstream media covered it extensively.

Long term investors that have a balanced and diversified portfolio matched to their risk tolerance have minimal exposure to stocks like Gamestop and the volatility it has caused. When we use history as a guide, we have seen that any short-term market changes from a short squeeze are just that – short-term.