10 March, 2021 Investment Services Wealth Management

How Short-Selling & Short Squeezes Work

Investor looking at phone

Written by Dan Bick


The phrase “stock market” tends to conjure images of a frantic floor at a busy stock exchange on Wall Street, full of people yelling “Buy!” or “Sell!”


If we don’t think of that, we likely think about the media coverage and news cycle surrounding today’s stock market.


In particular, the recent “short squeeze” of Gamestop stocks, fueled by Redditors, has been top-of-mind for many.


While there’s no denying the stock market’s ability to create wealth, it’s not always an easy sell for those who are new — or who may not fully grasp how it works.


Here’s a quick outline of how the modern stock market works — and why we shouldn’t be concerned by the recent headlines.

What is the stock market and how did it start?

In the 1600s, the Dutch East India Trading Company employed hundreds of ships to trade gold, porcelain, spices and silks around the world. Running this enterprise was expensive. The company turned to private citizens for investments. These investors would pay money to fund trips, in exchange for a share of the profits. 


As the voyage funding increased, so did the profits!


By selling these shares in shipping ports and coffee houses, the company ended up inventing the world’s first stock market. Since then, companies have been collecting funds from willing investors to support all sorts of business ventures.


However, the modern stock market is much more complicated than its original prototype.

How does the modern stock market work?

Today, stock markets operate around the world. Companies can “go public,” meaning they start selling stock in their company to willing investors. These first stocks offered by a company are called the Initial Public Offering (IPO). Lately, this has been replaced with Special Purpose Acquisition Companies (SPACs), an already public special purpose acquisition vehicle that merges with the company selling stocks. The results are the same. 


Anyone can buy stock in these companies, and investors become partial owners of the business because each stock is a “share” in the company. As the company grows, more people will want to buy stocks in order to grow their own personal profits. This demand raises the value of the company, including the stocks that people already own. 


But, the opposite can happen too. If investors think the value of their stock is going to decline, they’ll try to sell their stock for a profit before it declines in value. The value can go up and down depending on supply and demand. 


There are also a range of market forces at play, like the cost of materials, production technology and labour. These can drastically affect a company’s profitability and the price of their stocks. Changes in leadership, bad publicity and new laws or trading policies are also factors to keep in mind. A company’s given value can see-saw every day, and how successful a company appears will affect how much people will want to invest.


Since this human element makes the market unpredictable in the short-term, professionals — the Bick Advisors team included — recommend stable and predictable long-term strategies for your goals.


This brings us to the Gamestop phenomenon we’ve been seeing in the news in 2021.

What happened with Gamestop?

The internet has changed how we invest. Normal, everyday people can now invest with the same tools that major investors use, supporting businesses they believe in and meeting their financial goals while they’re at it.


What happened with Gamestop was something called a “short squeeze” — a type of investing that has been going on for decades. 


Short squeezes are a result of “short selling.” In short selling, investors speculate on the decline in a stock’s price — borrowing the stock, selling high on the stock before it drops, and then buying it back again when the price lowers (to repay the borrowings). This happens very quickly, often over the course days — hence why it’s called “short” selling.


In a short squeeze, a stock or other asset jump sharply higher instead of lower (as speculated), forcing traders who had bet that its price would fall to buy it to prevent even greater losses. Their scramble to buy only adds to the upward pressure on the stock's price.


These squeezes happened repeatedly with Gamestop stocks in 2021, with a dramatic rise in price — and subsequent price crash. A large group of Redditors — users from the social news aggregate website, Reddit — decided to buy Gamestop stocks to drive up its price. Among those betting against the company were a variety of hedge funds and other players who had an outstanding short interest against the stock.

Can what happened with Gamestop have the potential to destabilize the entire stock market?

In short, no. While it might cause short-term volatility, these kinds of bets just don’t have the volume to affect the stock market as a whole.


Even if Gamestop were to cease to exist and wipe $23 billion off the face of the earth, the S&P 500 alone is worth a total market cap of $32 trillion. Gamestop isn’t even worth 0.1% of that. And that’s just one index from one country!


For this reason, we advise a long-term view when it comes to investment strategies. No matter how appealing short-term gains from short squeezes might appear, they’re just too risky. With a solid strategy and some patience, you can invest, stay put and exceed your financial goals if you hold onto your stocks.


Recently, Investment Planning Council’s Corrado Tirralongo wrote an excellent piece on how the fear of missing out (FOMO) shouldn’t affect our investment decisions. We couldn’t agree more.

If you’d like to talk more about investment strategy, please get in touch with our team to set up a meeting.