The last couple of days have been entirely unprecedented in the history of trading. While I’ve followed the frenzy, I hadn’t realized just the true magnitude of it until I got an email from my brokerage about it. There are two reasons I didn’t pay all that much attention to the craziness that has gone on the last few days.
- I’ve seen it happen before. In 2018, the stock of Tilray (A marijuana company) had gone bonkers in similar fashion. Some of this behavior has also happened with Tesla in the past and I still think that Tesla is going to turn out to be a bad investment or a lot of people in the long run (I know it is the unpopular opinion but I am sticking with it).
- I was perfectly happy sitting on the sidelines and watch it play out.
One of the stock involved in the frenzy is AMC Entertainment (The movie theater chain and not the network ‘The Walking Dead’ was on – They are different stocks and in today’s crazy market, that is worth noting). I’ve followed AMC for many years. I even owned it for a while back in 2015 and made some money off it. Eventually, I sold it due to the threat of the rise of streaming services. I figured it’d be very hard for the movie theater story to grow given the preference for streaming. I am thoroughly glad I got out because COVID has not been kind to movie theaters for obvious reasons. I contemplated buying AMC for a couple of weeks in January based on if they’d be able to raise cash to avoid bankruptcy and decided it was too risky of a bet to get in.
If I would have bought in a few days ago, I would’ve quadrupled my money. The kicker is, I decided not to buy it and I don’t have a least bit of regret about it. Why? Because I lost no money. When you’ve evaluated the risk in a particular investment and determined that the risk is beyond your tolerance levels, you shouldn’t look back. In short, you have to trust the process when you know the process works. You cannot get emotional when it comes to investing. It is a recipe for disaster.
Lets talk about what is happening though. Hedge funds are institutions that bet on macroeconomic trends. Essentially, they look at the movements in the global economic and social trends to try and predict the future to profit from. With the ascent of Amazon, malls have been struggling which is where Gamestop has most of their stores. As COVID forced studios to release movies on streaming services, movie theater chains are losing that battle even quicker than they already were, making the future for companies like AMC bleak. The hedge fund predictions would then be that these stocks are likely to underperform and eventually disappear making it logical to bet against these companies.
To explain the phenomenon short selling (betting against companies) in normal terms, let me tell you a true story. A neighbor of mine wanted to paint his fence. I had recently purchased a paint sprayer and painted my fence so I told him I’d be happy to lend him mine. He borrowed it one weekend and I gave him the sprayer including the instruction booklet. Towards the end of his paint job, he made a mistake of detaching the paint canister from the sprayer without releasing the pressure first and a bunch of paint got sucked into the motor causing the sprayer to malfunction. Since the sprayer he was using was borrowed from me and he didn’t want to live next to a pissed off neighbor for the coming years, he let me know exactly what happened and assured me he would buy me a new one. What if he went to the store and found out that the sprayer now cost twice as much as what I paid for it just a few weeks ago?
Essentially, the way to bet against a stock is by selling a stock ‘short’ or selling a borrowed stock. You sell stocks in the market that you do not own YET. Once you’ve sold these ‘borrowed’ stocks at market price, you are said to have acquired the short position and you hope that you can purchase it back on the open market at a later time when it is cheaper. When you acquire a short position however, you also make a promise that you will maintain enough cash in your account at all times to be able to buy back the stock on the open market to cover your short position which shouldn’t be a problem if the stock price goes down. When my neighbor decided to borrow my paint sprayer, he knew full well that if he broke it, he’d need to buy me a new one. It is the same concept with shorting stocks. The primary difference is that the price of stocks fluctuate every day. Meaning, when my neighbor broke my sprayer, it is possible that when he goes to the store to buy a replacement for me it may be cheaper or more expensive but that doesn’t matter. He needs to buy it because he owes it to me.
This exact phenomenon took place. Hedge funds had massive short positions on these stocks. They had sold a lot of borrowed shares in the market hoping to buy back at a later time when it was supposedly cheaper to buy pocketing the difference. In the case of AMC, they were on the verge of bankruptcy anyway. If they’d gone bankrupt and their stock was delisted, they would have pocketed all of the money they received from selling the ‘borrowed’ stock. However, as the prices went up, they needed to maintain enough cash in their accounts to make sure they could buy back what they had ‘borrowed and sold’. As the stock price went up, they needed more and more cash. So then they decided to cut their losses and actually buy at a loss. But no-one was selling so they had to bid higher and higher and higher to the point where they executed trades at ridiculous prices losing a lot of money themselves and making the people who had actually purchased real shares (not borrowed) hoping the prices will go up, a lot of money.
There is a lot of anger amongst people about brokerages limiting people from trading these stocks. I am not taking a position on limiting trading on these stocks by brokerages was right or wrong but circuit breakers have always been part of the market. Whenever there are massive swings in the market, trading is stopped for a while to allow emotions to cool down because as I said in my last article, money and emotion are pretty much impossible to separate and sometimes, it is important to stop the dominoes from falling.
What we do need however is regulation driven simplification of our financial markets. There is too much money changing hands on too many ‘innovative’ financial products. The media will invariably cover what is sensational adding fuel to the fire but in the end, the investor that invests with the foundation of the sound fundamentals of investing will invariably come out on top.
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