Last week the stock market was thrown right into the main stream discussion in ways it never has before. It has left a lot of people wondering WHAT IS HAPPENING WITH THE STOCK MARKET!?
For starters, you should know that none of what is happening has anything to do with real investing. The stories you heard last week and what will be ongoing discussions for the following few weeks are essentially gambling where several bets went very wrong for some very wealthy people and some smart everyday people wreaked havoc on Wall Street.
To best understand what’s happening there are some terms that you need to know the definition:
Hedge Fund: A hedge fund is a group or partnership of investors that use high risk investing methods to realize higher gains in the stock market. They are typically wealthy investment groups that use borrowed money or often times have institutional investors backing them with funds from 401k’s and Pensions.
Short Selling: If an investor believes a stock is going to go down in price by a certain date, they can make profit off of that loss in value by borrowing a share of that stock from their broker and sell it on the market today. Then in the future when that stock has a lower price, they can buy the stock back at the lower price and return the share of stock to their broker. The investors profit is the difference between what they sold the stock for initially and the lower price they’re able to buy the stock for in the future.
Retail Investors: If you’re independently investing in the stock market without the assistance of a fund manager, stock broker, or financial advisor utilizing online platforms like Robinhood, ETrade, WeBull, or others, then you fall into a category known as retail investors.
How to profit when the stock price goes down.
If you owned a stock today but believed it was going to go down in price over the next 60 days and that the highest price you could sell that stock for is the price it is selling for today, you would sell that stock today.
But what if you don’t actually own the stock today and are confident it’s going to drop in price in the future? This is where Short Selling a stock comes in. You borrow a share of stock from your broker and sell it today. Short sales have an expiration date in which you must return the share of stock back to your broker.
Investors then make money on a Short when the price of the stock does indeed drop. They sell it today at the highest the stock can sell for and buy it in the future at a lower price so they can return the share of the stock back to their broker. The risk of course is that the price doesn’t go lower but instead goes higher. In this case, the investor that borrowed the stock has to pay more money to buy the stock and return it than the amount they made when they sold the borrowed stock.
What happened this week on the stock market?
A group of retail investors who have been reading a Reddit thread online, primarily run by a group called Wall Street Bets, discovered that several stocks had been shorted by some hedge funds. What they discovered is that these stocks had been over-shorted, meaning that more shares of the stock had been sold short than actually existed on the market.
The hedge funds borrowed and sold more shares of stock than they can now buy and return to their brokers. The time for returning the shorted shares is basically now. The only way the hedge fund makes a profit on the deal is if they can buy back the stocks at a lower price than they sold them for.
These retail investors have chosen to go all in on the stocks that the hedge funds shorted. The sudden increase in buying activity on these specific stocks has caused their trading price to be above what the hedge funds sold them for. Now the hedge funds have to scramble to buy back the stocks thus creating more buyer demand and sending the price of those stocks up higher. The longer the retail investors hold on to their shares, the higher the price will go until the hedge funds can return all of their shares of the borrowed stock.
In order to “cover” their short position losses, the hedge funds have had to sell some of their long positions (stocks they like and that are increasing in value). This sudden sell off of high quality stocks caused the prices of those stocks to also go down, and lowered the overall Dow Jones Average.
The Controversy
There has been a tremendous spike in the volume of transactions occurring as a huge number of new retail investors have jumped into the market. When you open a new brokerage account and deposit money into that account, the money doesn’t immediately transfer. It takes a few days to go from your bank account and be received by your brokers account. The brokerage will still typically allow you to make trades during the waiting period, you just can’t cash out until your funds have all cleared. This has caused strain on the infrastructure system for brokers like Robinhood who cater to the retail investor. To put it most simply, these brokerages had to make a choice to either limit their financial exposure or allow all of these trades to go through even if there were issues a few days from now getting the actual cash transfers into the bank. The controversy here is that retail investors clearly wanted to participate in the market and buy into these various securities they were hearing about on the news and social media. These new investors buying into those securities could have and should have allowed the price of those securities to continue to rise. Because of the limits placed on the retail investors which limited the number of shares of a security could be purchased or held, the price of the securities didn’t rise as much as anticipated which scared off many of the retail investors into selling their securities for a loss. This ultimately allowed the hedge funds to buy back those same securities at a lower price than they were going to be buying them for.
On its surface, what it appears is that the brokers facilitated “stealing from the poor to give to the rich,” which is the opposite of Robinhood. These retail investors overpaid for a stock with the almost certain knowledge that it was going to increase anyway. However due to the actions these brokerages took in limiting purchase transactions, they squashed the price trajectory of these securities. These actions helped hedge funds minimize their losses and cost retail investors losses.
What does all of this mean for the average person?
Ultimately, the value of a company and the price of their stock are typically somewhat equal. Occasionally things get out of whack, like they are right now. The underlying assets in the middle of the stock market mess this week are brick and mortar companies that have had their doors closed for the past 6-9 months by the government in the middle of a pandemic and were already being subjected to digital changes in their markets. The reality is, their stock price likely should not be what it is trading for today. It likely won’t be trading at anywhere near this price 6 months from now.
This is not investing. It is gambling. It is trying to find the perfect time to jump off of a rocket ship in order to profit and if you miss the mark, you will lose money. If you want to play in that game, fine. Just be careful to only invest what you can afford to lose. Don’t bet your rent money on this fiasco and don’t change your long term financial strategies on a whim.
Real investing is following a disciplined strategy of making consistent investments over time into a well diversified portfolio. For the average person, payoff your consumer debts and build a small emergency account to free up your monthly cash flow. Then use your income to follow a proven investment plan that will help you build wealth.