When Will This Game Stop?
>Smaller investors are making a big impact on Wall Street by joining together to buy companies such as GameStop, AMC, BlackBerry, and Nokia.
>The targeted buying is hurting hedge funds shorting these stocks, creating a short squeeze.
>The “short squeeze” is helping drive up these companies’ stock prices to astronomical heights.
>Currently, hedge funds are the biggest losers, but if stock prices reverse, there could be a ripple effect.
If you’ve been monitoring the news recently, you’re likely to have heard something about a company called GameStop. While there have been further developments this past week, this article will focus on the basics of how we got here and the potential impact on those who have not directly purchased GameStop.
What are people buying?
When someone believes that a company will increase in value over time, they buy (or go long) a stock. The risk of loss to the investor is limited to the money they used to purchase the stock.
When small investors buy or sell stocks, they rarely have much of an impact on the stock’s price. Recently, a group of small investors banded together and started buying GameStop, AMC Entertainment, BlackBerry, Nokia, and others. They are targeting companies that hedge funds have been shorting to drive up the price at a rapid rate.
What is being short a stock?
When someone believes that a company may go down in value, they can short a stock. The investor borrows stock from someone else and then immediately sells it.
They will buy the shares later (hopefully for less than they sold them) and return the shares to the lender (covering their shorts). The investor does not want to see the stock price rise because any price increase is considered a loss. When an investor shorts a company, their loss potential is unlimited.
What’s happening with these companies?
Through forums such as Reddit, small investors have launched a coordinated buying effort to push up the price of companies in which hedge funds have large short positions. Already risking millions, hedge funds have been returning borrowed shares at a rapid pace to limit their losses. As hedge funds buy the stock to cover their shorts, that further drives up the stock’s price (a short squeeze). It’s creating an updraft for these companies where many investors are seeing their stocks double (or more) in a single day.
Who is this hurting?
Hedge funds that shorted these companies are losing millions. Simultaneously, small investors (many of whom dumped their life savings into these companies) are reaping the rewards-at least on paper. At some point, the party may end just as quickly as it started.
If the short squeeze ends and there’s less buying of the shares, we could see these stocks drop at an incredibly rapid pace. Those small investors who have seen massive gains on their statements may not get out in time to lock in those gains. Those investors who started buying late may suffer significant losses.
In the end, the biggest winners are likely to be those who sold their shares before the tide turns, the people who started this movement, and any hedge funds that maintain their short positions.
Could this affect the rest of the market?
Probably not. Most of the broader market will likely continue unphased by this activity. That said, if you own a mutual fund or exchange-traded fund (ETF), it’s possible that it could now have high concentrations of GameStop or the other short-squeeze companies. If those stocks start losing value, it could negatively impact you. You may want to look at your mutual funds/ETFs’ current holdings to see if you’re at risk.
Just as we say that you only have paper losses until you sell during downturns, so too do you only have paper gains until you sell when things are going well.
If you hold one of these companies, consider being prudent with your investment at these levels. Talk with your financial advisor to see if it makes sense to pare back a portion of your holdings to lock in your gains.
The opinions voiced in this material are for informational purposes only and are not intended to provide specific advice to any individual. Consult your legal, tax, and/or financial advisor to determine what is appropriate for your situation.
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