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Wall Street: Short selling and short squeezes explained
In most cases, profits are made in the stock market as the price of a share rises. But short sellers can make money as value drops and lose money as it rises.
LOS ANGELES - If you’re confused as to why GameStop is shaking up Wall Street, you’re not alone.
Earlier this week, trading volume surged in shares of GameStop, AMC Entertainment, as well as Bed Bath & Beyond and BlackBerry, stunning Wall Street firms betting that the value of those stocks would fall.
The surges came from small retail investors with trading accounts ranging from $500 to $2,500 banding together in an economic tug-of-war against major investment firms.
Companies like Citron Research and Melvin Capital had placed bets that GameStop shares would fall in a practice called short selling.
What is short selling?
It's how investors can make money off a stock falling.
In a short sale, they borrow a share of GameStop and then sell it. Later, if the stock price does as they expect, they can buy the stock at a lower price and keep the difference. GameStop is one of the most heavily shorted stocks on Wall Street.
But small-time investors weren’t having it. They banded together, helping to raise the stock price of GameStop to stunning levels.
These smaller investors are using Reddit and other discussion boards to encourage each other to buy GameStop resulting in what’s known as a short squeeze.
One Reddit group in particular, "WallStreet Bets" consists of discussions full of ideas for the next big trade to jump on, self deprecation and an appreciation of both winning and losing bets — as long as they're bold.
They've recently been encouraging each other to keep buying GameStop to push it even higher, or "to the moon."
After sitting at around $18 per share three Fridays ago, GameStop’s stock value doubled in four days. It kept shooting higher, before nearly doubling on Tuesday and then more than doubling again on Wednesday to $347.51. On Thursday, it gave back a chunk of those gains and finished the day at $193.60, down 44%. But it was still up an amazing 928% through the first few weeks of 2021.
While short selling can be profitable, the practice is not without risk: Gains from short selling are limited (a stock can only go to zero), but the losses don’t have a cap as there is no limit as to how high a stock’s price may climb.
Short-selling is loathed by many CEOs, including Tesla’s Elon Musk, who declared that the practice "should be illegal."
What is a short squeeze?
It's what happened with GameStop's stock.
When a stock is very heavily shorted, a rise in its price can force short sellers to get out of their bets.
To do that, they have to buy the stock, which pushes the stock even higher and can create a feedback loop. As GameStop's short sellers have gotten squeezed this month, smaller and first-time investors have been egging each other on to to keep the momentum going.
Do these smaller investors believe in GameStop?
There's been a flavor of that in the discussions. But lately it's been more about inflicting pain on short sellers, hedge funds and other big financial firms. Many talk about it in terms of evening the ledger with the financial elite, who benefited from years of gains as other people fell further behind.
Buying GameStop "isn’t about greed," one user wrote on Reddit, after citing all the recessions "they" caused and the times "they" got bailed out with taxpayers’ dollars. "It’s about taking back what’s ours, what we’ve already paid for."
"This is for making us work on Thanksgiving night all the way through black friday at 9.50 an hour," another user wrote on Reddit .
FOX Business and the Associated Press contributed to this story.