What GameStop Teaches Us About Short Selling and Margin Trading

“He who sells what isn’t his’n usually winds up in prison”

When I got licensed as an investment advisor in 1985, several brokers shared this line with me. It’s stuck with me, and it’s a great way to think about short selling.

The GameStop stock trading story is a great way to explain short selling and margin trading- two topics that individual investors must understand.

What’s happened

As you may have read, a large number of individual investors, communicating on Reddit, are buying GameStop common stock, creating a huge surge in the price. Here’s the last 5 days of trading, as of the close on January 28th:

Insane volatility, right? Many of the investors trade through the Robinhood investment app.

Hedge funds, including Melvin Capital, had sold GameStop short, meaning that they sold stock they didn’t own. The hedge fund is betting that the stock will decline in value, and they can go into the market, buy it cheap, and deliver the shares they have sold.

But there’s a problem- what if the stock price keeps going up?

The shares you must buy get more and more expensive. Remember: the short seller is obligated to deliver shares to the buyer. The securities industry requires it, so that every buyer knows that they is a seller who will be delivering the stock.

How high can the price go up?

The price increase is unlimited- and the risk to the short seller is unlimited. As of today, Melvin Capital has closed its position, meaning that they bought share of GameStop at a much higher price, delivered the shares, and took a massive loss.

The lesson?

Short selling exposes investors to an unlimited amount of loss, so avoid this investment strategy.

Which brings us to margin trading- less risk, but still risky.

Understanding margin trading

When you buy on margin, you borrow money for a portion of your investment. Now, the brokerage firm asks for security for your loan, and other investments in your portfolio (or cash) serve as collateral. You’ll also pay interest on the amount that you borrow.

Let’s say you purchase $10,000 in IBM common stock, and borrow $5,000 for part of the purchase. You put up $5,000 worth of General Electric stock as collateral.

If prices increase, great. You can sell your shares of IBM, pay off the loan, and come out ahead.

The problems occur when prices decline.

Let’s say the IBM position declines from $10,000 to $2,000. You put up $5,000 in GE stock as collateral, and you’ll have to deposit $5,000 in cash or sell your GE stock to cover the $5,000 loan.

What if IBM declines to $2,000, and your GE stock also declines in value?

You’re even worse off. If GE is worth less than $5,000, you’ll have to put in more cash (or other securities) as collateral. You may lose all of your GE stock- AND pay in more cash.

My two cents? Avoid short selling and margin trading all together. Consult with a financial advisor become making investment decisions.

Find great subscriber-only accounting and personal finance video and blog content on my Patreon page. Good luck!

Ken