This article is part two of a three-part series about the recent GameStop saga. You can find the first article, “GameStop and the Short Squeeze” here. Today we are talking about short selling and its role in a healthy market. 

Remember those Merrill Lynch commercials from years ago that stated “We are bullish on America”? It’s a great sentiment, but inviting everyone to be bullish is actually not good for the markets. If everyone leans bullish (or bearish) the boat can tip over. This is why we need short sellers.

What is short selling?

It’s simply taking the other side of a bullish trade. Instead of betting the price will go up, you bet the price will go down.

Here’s how it works: A trader borrows a stock, sells it, and then buys it back to return to the lender. The trader does this because they believe the price or valuation is too high. They wait patiently for the stock to fall in price, and if it does, the short seller will “cover” their position at a lower price. The difference is a profit for the short seller.

There are numerous reasons for short sellers to open a short position, but valuation is certainly a good reason. This is what happened with GameStop. The retailer is on the precipice of extinction thanks to online gaming (and their inability to respond). Fund managers believed GameStop would eventually roll over and die, so they took short positions. Melvin Capital Management had a massive short position, which is why that name popped up in the news.

Now, the one caveat with short selling is if the stock rises above your capital requirements you will eventually have to “cover” your position, aka, buy the stock back. You’re betting it’ll be at a lower price, but it could be at a higher price. Buying it back may trigger more buyers to pick up the stock, thus undoing the short seller’s position.

This is what happened with GameStop. Traders that followed Wallstreetbets on Reddit piled into the stock and boosted demand. Prices rose – and they kept rising through January. Melvin Capital and other short sellers never dreamed in a million years that GameStop would rise up as it did. But that’s the other side of trading. If someone is long, someone is short. It’s a zero-sum game.

Shorting stocks is not a “bad” activity

Authorities are investigating the GameStop saga, which makes it look like short selling is “bad”. It’s not. 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 long stocks, the markets could conceivably crash far more often.