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Here's how short-selling works, and how Reddit's day-trader army spoiled the strategy for GameStop bears

Business Insider logo Business Insider 1/27/2021 (Natasha Dailey)
a sign on the side of a building: GameStop. REUTERS/Mike Blake REUTERS/Mike Blake © REUTERS/Mike Blake GameStop. REUTERS/Mike Blake REUTERS/Mike Blake

Short-sellers have taken a hit now that GameStop shares have topped $330, in what analysts have dubbed an irrational rally stoked by the Reddit group "Wall Street Bets." 

Investors always have the option to short a company's stock. In the case of GameStop, Melvin Capital and Citron Research were among the list of short sellers, and they've lost their bet, by a lot. Members of the subReddit group, which has more than 2 million users, have been bidding up GameStop shares in the past weeks, causing the stock to skyrocket more than 1,200% since mid-January. 

And short sellers have lost billions

To short a stock means the investor is betting the price of that company's shares will decline. (In a normal bet, which is called going long, investors purchase a stock with the hopes of it increasing).

In shorting a stock, an investor borrows shares from a lender, let's say at $10 per share. The investor then takes the borrowed shares and sells them for that same price. Once the stock goes down, to let's say $1 per share, the investor buys the shares back and returns them to the lender, pocketing $9 per share. 

"Let's say you short XYZ company at $100, and the next day it goes to $10. You take $10 out of your pocket and buy back the stock and give it to the guy you borrowed it from. And you have $90 in your pocket," Michael Pachter, an analyst at Wedbush, told Insider. Pachter added that there's the added cost of paying the interest on borrowing the stock, though if an investor only holds a short position for a month, the interest would be negligible. 

But sometimes, like in the case of GameStop, the shorts get "squeezed" when the shares go up, said Telsey analyst Joe Feldman, who maintains the Street-high target price of $33 for GameStop. The buyers of the stock send the price up forcing the shorts to close their positions and become buyers, sending the price even higher. So if the shares were borrowed when the stock was $10, and now the stock is $20, the investor loses $10 per share. 

Read more: How hedge funds are tracking Reddit posts to protect their portfolios after the Wall Street Bets crowd helped tank Melvin Capital's short positions

GameStop short-sellers Melvin Capital and Citron Research lost a lot when the stock started spiking, said Pachter. They've both since closed out of their short positions. CNBC reported that hedge fund Melvin Capital ate a huge loss on Tuesday when it closed its short position. Citron managing partner Andrew Left said that the firm's position was covered when GameStop traded at about $90 at "a loss of 100%."

"There's a point where the shorts say, 'This is crazy I'm getting out,'" Pachter said. 

The problem with shorting the stock at the higher price now, betting it will go back to normal levels, is that analysts are unsure where the irrational share increase will stop. "What if it goes to infinity?" Pachter said.

Joost van Dreunen, who teaches at the New York University Stern School of Business and has an expertise in gaming, said the current valuation of GameStop is "totally disconnected from reality." GameStop's record highs prior to this rally were in 2007 and 2013 when the Nintendo Wii and Switch launched, respectively, and pushed the stock to about $60. 

"That was their absolute high watermark, and they haven't been able to recover it since," van Dreunen said. "The current situation is just post-modern financial drama totally void of reality."

"Fundamentally, nothing has changed for the company," Feldman said. "If anything the fourth quarter was probably a little disappointing."

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