Short-selling is an important part of the stock market

Do you remember the Merrill Lynch commercials many years ago that said we are “Bullish on America”? It does not get better than that, and to have a great dissemination that welcomes everyone to participate, well, what can go wrong?

Certainly I am exaggerating here, because when everyone is leaning up, the boat can capsize too much on one side. But who would make money if long-term shareholders lose? It’s probably the card sellers.

What is short-selling? It simply takes the other side of a bullish trade. Someone is selling a stock (without owning it) because they think the price or valuation is too high. Then they patiently wait for the stock to fall again, and if the card seller is right, they will “cover” their position at a lower price. The difference between this price and their original selling price of the shares is a profit for the card seller.

There are many reasons why traders open a short position – too many to mention here. However, valuation is certainly a good reason, as we recently saw with GameStop (GME) stock. This dealer was on the verge of extinction very quickly, with new technology just rolling them over. Think Blockbuster, the disused video rental store that fell off the side of the road.

Some short-selling fund managers figured this out and thought GameStop would eventually roll over and die. In fact, one company, Melvin Capital Management, had a massive short position. The only caveat with short-selling is that if the stock rises above your capital requirements, you will eventually have to cover if you buy the stock back – perhaps at a higher price. And that purchase can get more buyers to come in and pick up the stock, completely unrelated to why the card seller initiated a position!

It becomes a function of demand vs. tender. When there is a “pile on” effect and demand is strong with less supply to meet demand, prices will rise. That’s what happened to Melvin Capital and other card sellers who were complacent and never dreamed for a million years that GameStop would rise the way it did. But it’s the other side of a stock story – if anyone’s long, anyone’s short – it’s a zero – sum game.

Did something go wrong in this recent saga?

Some authorities are investigating for malicious activity and affecting reddit posts and front positions. But in the end, short sellers give a good balance in the market, because as we know, markets do not go up every day. If there were no short sellers in the markets and all were just long stocks, the markets could conceivably collapse far more often with just a little panic.

Emotions can run high, but short sellers are a good balance between the market.

Next time we will have the last article in this three-part series. We’re talking about risk management. click on here to part 1 of the series, on short clamps.

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