Remember those Merrill Lynch commercials years ago saying we are "Bullish on America"? It doesn't get any better than that, and to have a big brokerage welcoming everyone to participate, well, what could go wrong?
Certainly I'm exaggerating here, because when everyone leans bullish the boat can tip over from too much weight on one side. But who would be making money if long stockholders are losing? It's probably the short-sellers.
What is short-selling? It's simply taking the other side of a bullish trade. Someone sells a stock (without owning it) because they believe the price or valuation is too high. Then, they wait patiently for the stock to fall back down, and if the short-seller is right they will "cover" their position at a lower price. The difference between that price and their initial sale price of the shares is a profit for the short-seller.
There are numerous reasons for traders to open a short position -- far too many to name here. However, valuation is certainly a good reason, as we saw recently with GameStop (GME) stock. This retailer was on the road to becoming extinct very quickly, with new technology just rolling them over. Think Blockbuster, the defunct video rental store that fell by the wayside.
Some short-selling fund managers figured this out, and believed GameStop would eventually roll over and die. Indeed, one firm, Melvin Capital Management, had a massive short position. Now, the one caveat with short-selling is if the stock rises above your capital requirements you will eventually have to cover buy the stock back -- maybe at a higher price. And that buying may trigger more buyers to come in and pick up the stock, completely unrelated to why the short-seller initiated a position!
It becomes a function of demand vs. supply. When there is a "pile on" effect and demand is strong with less supply to meet the demand, prices are going to rise. That is what happened to Melvin Capital and other short-sellers, who were complacent and never dreamed in a million years that GameStop would rise up as it did. But that's the other side of a stock story -- if someone is long, someone is short -- it's a zero sum game.
Did something go wrong in this recent saga?
Some authorities are investigating for nefarious activity, influencing reddit posts and front-running positions. But in the end, short-sellers provide a good balance to the market, because as we know, markets don't go straight up every day. If there were no short-sellers in the markets and everyone was just long stocks, the markets could conceivably crash far more often with just a little panic.
Emotions can run high, but short-sellers are a good balance to the market.
Next time we'll have the final article of this three-part series. We'll talk about managing risk. Click here for Part 1 of the series, on short squeezes.