Hot Shorts Summer

Traders who bet on bad news are the necessary foils of meme stocks

By Brandon Kochkodin

There’s something a little weird about short selling. Shorting—or betting that a stock’s price will fall—is a feature of finance that doesn’t have a close analogue in the real-world economy.

Buying a stock you like isn’t much different from purchasing a product that catches your eye. But if you’re walking through the local grocery store and see an item that sets your stomach turning— say, ketchup-flavored potato chips—you don’t stand in the aisle waving off other customers, telling them how bad it is. You don’t try to crush the bag. You just think, “Who in the world eats this … ” and go on your merry way without putting it in your cart.

On the stock market, you can do more than just ignore the stuff you think is lousy. You can actively hunt down weak companies or overpriced stocks and try to profit from their decline. Shorting is an old practice—Napoleon outlawed it—that’s become a taken-for-granted part of modern finance. Hedge funds couldn’t hedge without some form of shorting; it’s a kind of insurance that something in a portfolio is making money even if the market falls.

And right now a lot of people hate it. A common thread among many of the stocks retail investors have embraced—including GameStop Corp. and AMC Entertainment Holdings Inc.—is that they’ve also been targeted by short-sellers. The traders who call themselves “apes” on Twitter and Reddit discussion boards see themselves as an army at war with the short sellers from elite Wall Street.

In fact, fans of these so-called meme stocks are locked into a symbiotic relationship with the shorts. Part of the reason GameStop and AMC were launched to the moon is that a frenzied group of traders thought they had an opportunity to make money by overpowering the short bets placed by hedge funds.

To see why, you need to understand the mechanics of shorting. Take GameStop as an example. Prior to its explosive jump in price early this year, hedge funds and other traders were arrayed against the video game retailer. That wasn’t crazy: Brick and mortar stores were hurting even before the pandemic, and GameStop’s main product is digital and increasingly sold over the internet. To short the stock, bears could borrow some shares—typically from a large money manager—and then sell them. Later they’d have to buy back the stock to return it to the owner. But if they were right and the shares fell, they could pocket the difference between the new price and the one they sold at. (Traders may also go short using options contracts.) In January, 140% of GameStop’s free-floating shares were tied to short sales. This can happen because a single share can be borrowed, sold, and then borrowed again from the new owner.