Dispelling Short Selling Myths

Let’s look at the share price of GameStop from an economics perspective. In other words, analyzing supply and demand. There has to have been an increase in demand, a decrease in supply, or a mixture of both that led to GameStop’s (aka Gamestonk) share price skyrocketing. 

At the heart of the story is short selling. This is how the “evil” hedge funds got us to this point, by selling short 120% of the company’s stock! There is a lot of misinformation here. The best way to fully understand what’s going on is to break everything down to manageable chunks.

What is Short Selling?

In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value by a set future date... The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.

Here’s a simple hypothetical scenario. I own a LeBron James rookie card valued at $10. A friend of mine wants to “short” the card because he believes the value is about to decrease. He borrows the card from me and sells it to someone else at the current valuation of $10. Then my friend is proven right when the price of the card decreases to $5. He finds someone else willing to sell their card for $5, buys it from them, returns the card to me, and just like that pocketed money. 

However, there is an asymmetry between his risk and reward. The lowest the card could be worth is $0, and in theory there is no limit to what the card could be selling for. 

The Mechanics of Short Selling

Now let's take the same scenario and fill in a few more details to accurately depict what goes on in financial markets. 

For me to lend my friend the card I own, I’m going to require him to give me $10.20 as collateral. That way if he doesn’t get me my card back I won’t be left with nothing. 

He doesn’t have the $10.20 to pay me, so he borrows the money from his dad and borrows the card from me on margin (borrowing money from a broker in order to purchase stock). As a condition of borrowing money, his dad charges him interest. 

Also, for the privilege of borrowing my card, I’m going to charge interest daily. Especially if this card was rare and difficult to borrow, the longer my friend borrows it the more interest he’ll have to pay me. This is called a stock loan fee (a fee charged by a brokerage firm to a client for borrowing shares).

There’s another piece to this stock loan fee. Let’s say my card jumps in value while it’s being borrowed, or becomes even more difficult to borrow, or more people want to borrow my card, that daily fee is going to increase. 

To calculate the fee we have the borrow rate and market value of the card (both vary due to the above factors), and it looks like this:

((Borrow rate) x (market value)) / 365

So if the rate starts off at 20% and the market value is $10, the daily fee is $0.005. 

My friend has to worry about paying his dad interest, paying me a fee for borrowing, and also hoping that the price of the LeBron James card declines. No wonder why some people just buy put options instead (a contract giving the owner the right, but not the obligation, to sell–or sell short–a specified amount of an underlying security at a predetermined price within a specified time frame.)

Getting Back to GameStop

I had been struggling with two questions: 1) how were there “over 100%” shares sold short and (2) what is r/WallStreetBets really accomplishing here?

I get the sentiment that, with high amounts of shares sold short, these diamond-hands redditors want to buy up all the supply and refrain from selling. That way the hedge funds are unable to find replacement shares to return to lenders. Share prices would go “to the moon.” 

You might remember seeing that there were more shares sold short of GameStop than are available to trade. Let’s unpack this statement.

Let’s say my brand 25th Hour Ideas takes off in popularity and becomes a publicly traded company with 100 total shares, each representing 1% ownership. I decide to sell 50% of the shares to various investors and I make sure to hold on to my 50%. 

If I’m not parting with my shares, there are only 50 shares available in the market. This is called float adjusted (only counts those shares that are available to investors and excludes closely held shares or shares held by governments or other companies). 

Now we are familiar with all the component parts of the short interest ratio, the ratio that people are throwing around in the media and on r/WallStreetBets.

The short Interest ratio is a simple formula that divides the number of shares short in a stock by the stock's average daily trading volume [float]. Simply put, the ratio can help an investor find out very quickly if a stock is heavily shorted or not shorted versus its average daily trading volume.

So in the numerator you have the number of shares sold short, and in the denominator is the amount of shares available for trading. Except that’s where we’re fooled! The denominator is missing something. Follow along with me here. Let’s go back to our LeBron trading card example.

My friend borrowed the card from me and sold it to someone else. Now there are three people involved: I have a long interest in the card (expecting price to increase), my friend has a short interest (expecting price to decrease), and the new owner has a long interest. 

What if that new owner decides to do the same thing I did and lend someone his card? The end result would be 3 people (me, the new owner, and the new-new owner) with a long interest, and two people (my friend and the new borrower) with a short interest… all from a single card! 

If you were to look at the short interest ratio, you’d have two short shares in the numerator and one card in the denominator. The card would be 200% sold short. Doesn’t seem that unfathomable, right?

With GameStop, and any other stock, this formula fails to account for these new “synthetic long” positions. Here’s a better explanation:

The ability of “synthetic longs” via margin, rehypothecation or lending programs to increase the overall lending pool in a security is why there is more liquidity for short sellers to access. As short selling increases, it in fact increases the ability to get stock locates as long share ownership expands and some of those shares are used in the stock loan market. It is also the reason why stock loan rates do not increase at a linear rate, but rather at an exponential rate as rates stay low until more and more of the “synthetic longs” settle outside margin, rehypothecatable or lending program accounts and no longer expand the lending supply universe.

This also explains why true stock loan based short squeezes are so rare, as short selling in a security increases the lending and keeps stock borrow rates relatively stable or growing at a slower rate for longer than if there was no “synthetic long” lending pool replenishment. But once we reach a tipping point where there is minimal or no replenishment due to new “synthetic longs” stock borrow rates skyrocket; stock locates become harder to get and recalls start hitting the street.

Here’s what it all comes down to… supply and demand! 

I had to read that article a dozen times explaining synthetic longs. Forget about that and think about the supply of GameStop stock. There are a “fixed” number of shares. So what would happen if I want to buy a share and none of these diamond-hands wants to sell me one. There are two options that would prevent the share price from going to the moon: (1) shares are sold short or (2) the company issues new shares. 

I doubt GameStop will issue new equity at the current market price (if they haven’t already). The SEC could put a stop to it like they did with Hertz, but GameStop is not in bankruptcy. 

That leaves us with needed short sellers to increase liquidity. Remember, by borrowing a share and lending it to someone else, the short seller creates a synthetic long position. That’s the solution to satisfy demand for shares. 

Short selling reduces prices because of the relationship between supply and demand, not because of nefarious reasons (usually). Also, on average, short sellers are important contributors to efficient stock prices.

What people on r/WallStreetBets are doing is trying to prevent shares from being borrowed via “margin, rehypothecation or lending.” 

Remember, if the supply of lendable shares dries up, short sellers will be faced with an exponentially increasing borrowing cost. 

The battle continues on Monday.