As a technique for getting control of a weak company on the cheap, it's probably not effective, because a short sale contract has an expiry date, at which time the parties must close their transaction. The recent short sale transactions involving Game Stop were interesting, in that the day traders discovered more short interest in Game Stop shares than there were shares. How is that possible? Because a short sale involves an owner of the stock lending the share to a short seller, shouldn't the number of shares outstanding be an upper bound on the extent of the short interest?
Not necessarily, which is the division of risks at work. Suppose I own some shares. I might contract with a short seller to lend him the use of my shares. The short seller pays me some rent, then executes the short sale. At the end of the short contract, the seller does not take ownership of my shares: he can close his position by paying back some of the proceeds of his short sale (the stock went down and he made money) or paying more than those proceeds if the stock went up. That's right, dear reader: the short sale contract is a derivative security. The value of the short contract is contingent on the value of my shares, but I get to keep my long position in the stock and get paid to make possible another investor's short sale. My long position is speculative. I expect the stock to appreciate. My participation in the short sale is a hedge. If the stock does go down, I get partial compensation for its lower price. It gets better. Suppose that I'm sufficiently persuaded by my stock being borrowed for use in a short sale that I take part of my rent payment and then take some profits, unloading the stock. The short seller who borrowed it doesn't have to know this. He's going to close out his position when the contract ends, although if his short is deep enough in the money, he might close it out sooner. The parallel to early exercise of an option is straightforward. Meanwhile, the subsequent owner of my shares also has the opportunity to hedge his long position by renting it out for a short sale. You read that correctly, dear reader: the same hundred shares of Game Stop or Acme Anvils or Enron have been shorted to two different short sellers. Do enough of that, and there is more short interest in the stock than there are shares outstanding. Because investors pay attention to such things, that is a situation ripe for a short squeeze, even without investors posturing to each other on social media.
Annie owns shares of GameStop, and Annie and her broker have an agreement that allows the broker to lend Annie's shares to short-sellers. It lends them to Bob, who subsequently sells those borrowed shares short in hopes that GameStop's share price will fall.In addition, I haven't exhausted the derivative securities I can create to further hedge my long position in the stock. I could write a call option. If Game Stop is selling for less than $5 a share, and its prospects don't look so hot, what's it worth to be able to buy it at $8 a share? Probably not a lot, but writing such an option against my shares is another way to make some money. This time, though, I'd best limit my option writing to one such contract, say at $8 or say at $15, because if I sell both options, once somebody exercises the $8 option, I've got nothing to sell out at $15. Now I have to come up with extra cash to close that position, if the owner of the option is after the money, rather than the shares. But that option activity adds to the short squeeze, as Bloomberg's Matt Levine explains.
An investor named Chris ends up buying those borrowed shares from Bob. However, Chris has no way of knowing that those shares have been borrowed from Annie. To Chris, they're just like any other shares.
More importantly, if Chris has the same kind of agreement, then Chris's broker can lend out those shares to yet another investor. Diane, another GameStop bear, can borrow those shares and sell them short.
In this example, the same shares end up getting borrowed and sold twice. The short interest volume these transactions add to the total is twice the number of shares actually involved. You can therefore see that if this happened throughout the market, total short interest would eventually exceed the number of shares outstanding and approach 200%.
This still might seem impossible, and in a sense, it is. But part of the answer lies in the fact that there are investors that don't currently possess actual shares of GameStop but who have the same economic interest as shareholders. They have the right to get back the shares they lent at any time. When you add together the actual shares plus these "synthetic" positions in the stock, the short interest can't exceed 100% of that larger total.
When you short a stock, you borrow shares and sell them, promising to return them later. You have to pay a fee to borrow shares, you have to post collateral based on the value of the borrowed shares, and you (generally) have to return the shares you borrowed if the lender asks for them back. When the stock goes up a lot, short sellers start feeling “squeezed”: Their borrow costs go up, they have to post more collateral, and lenders might ask for their stock back. Some short sellers might have to capitulate, and they will close their positions by buying back stock. There is a feedback loop: The stock goes up, short sellers give up, they buy stock to surrender, and their buying pushes the stock up more.So much for the dividing of risk. Might the hedge funds have been taking short positions in Game Stop and other older companies as a way of making a future purchase for the purpose of asset-stripping cheaper? Mr Taibbi might be thinking so. "[The Reddit trading] adds a potential extra layer of Schadenfreude to the plight of the happy hedge fund pirate who might have borrowed gazillions of GameStop shares at five or ten hoping to tank the firm, only to go in pucker mode as Internet hordes drive the cost of the trade to ten, twenty, fifty times their original investment." The American Conservative's Colin Martin might be concurring.
Second, a lot of people (on Reddit) who like GameStop don’t buy stock; they buy call options. If you are a retail trader looking to gamble on a stock, you can buy call options to get leveraged exposure to the stock.
Back in the [Wall Street Bets] community, the battle may be over, but the war has just begun. “People’s priority is certainly making money, but hurting funds that were hoping to bankrupt companies—especially companies that people hold fondly—is a huge motivational boost,” said a longtime WSB member with a background in finance. “I think funds will have to be a lot more careful with shorts and negative market manipulation in the future.”There's still the traditional way of getting control of a weak company: take a long position in it, even if that involves creative finance that might not pay off. Doesn't matter, the usual sort of scold will object to that sort of a takeover, too. "The online pranksters behind the great GameStop bubble of 2021 are probably going to lose a lot of money. But they’ve done the world a service by reminding us of the absurdity of the stock market." Really? What is more absurd, the takeover artist who is willing to use his own money to get control of the cash reserves of a traditionalist company, or the politician who is willing to use the government's monopoly on violence to get control of that cash?
For years, [Massachusetts senator Elizabeth "Fauxahontas" Warren has] positioned herself as a defender of average Americans and a critic of big finance. And in this case, she frames her argument as an indictment of the "hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades." Yet if the [Securities and Exchange Commission] were to intervene in the GameStop trades, it's more likely it would end up doing so in a way that benefited the big hedge funds who bet on the game retailer's fall. It would be to tip the scales against a movement that sees itself as a populist uprising.Never mind that, the usual suspects are piling on.
"Wall Street and stock market are metaphors for a society rotting from self-indulgence, greed, widening inequality, and financial entrepreneurship that builds nothing, improves nothing, creates nothing, and solves nothing, but merely moves money from one set of pockets to another," tweeted economist and former Labor Secretary Robert Reich in the early hours of Thursday morning.Mr Reich has been making such arguments for as long as I have been paying attention to industrial policy, where he first came to my attention. I don't recall there being Twitter, or fifth-generation smart 'phones, in 1980, nor can I find the line item in the federal budget that finances that service or those 'phones. There's a lot more in a similar vein at the link, including, as you might expect, "'The simplest solution,' [Zach Carter] wrote, 'is a financial transactions tax―a small fee attached to every financial bet. This tax will either discourage reckless stock betting and reduce the volume of what is a mostly economically wasteful activity, or generate a great deal of revenue that can be devoted to more useful activities.'" Like any other tax proposal, the revenue generation depends on the elasticities. Suppose, though, that there was a small tax on each of those Reddit-inspired trades. Would the short squeeze be of larger or smaller magnitude? Some people, like The Week's Ryan Cooper, never learn.
The United States was a much more equal and prosperous place when Wall Street was clapped in regulatory irons, and the economy was a lot more stable. It is momentarily glorious to see arrogant hedge fund guys get beaten at their own game, but the fact is that the Wall Street casino is rigged. The average person will almost always be beaten by the big, deep-pocketed players — particularly if he or she can't even afford to buy stock, which is the case for most Americans.When, exactly, was this era of greater equality and more prosperity, and where were the smart 'phones and designer coffees? Which contracts to divide and price risk are unnecessarily complex? Why isn't online trading, with or without a Reddit chat room, also a way to provide normal people trading opportunities in the securities markets? Finally, suppose the ownership of the large-capitalization companies was vested in a giant mutual fund. Who would be the board of directors, and would the managements of those companies have more freedom of action or less, compared with a regime in which the risk arbitrageurs, venture capitalists, and hedge fund operators disagree over who controls the company?
If we strictly regulated Wall Street with large capital requirements, a financial transactions tax, simply banning most of the complicated derivatives and options used today, and so on — aimed not at the retail investor but mainly at the big financial firms — the American economy would be a lot healthier. If we scooped most stocks into a social wealth fund owned equally by every American, normal people could benefit from the market without having to take crazy risks. There are better ways to beat the rich than pump-and-dump schemes.
Put another way, is Robert Reich or Elizabeth Warren really smarter than the distributed knowledge of individual and institutional investors?
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