The market went down about 620 points in January or about 2%. 2% is not a big deal. The market will likely recover from that quickly. Given that the group WallStreetBets caused a short squeeze of Gamestop and various other securities, the topic of this newsletter will be on defining what a short squeeze is.
There are two basic ways you can theoretically profit from a stock. You can go long (you profit when the stock goes up) and you can go short (you profit when the stock goes down). Going long is easier to understand. You bought a stock at given price, you sell it later at another price, and hopefully you sold it at a higher price than how you bought it. For example, if you buy a baseball card at 5 dollars, and later sold it at 10 dollars you engage in and profited from a long transaction. You made 5 dollars of profit. A short transaction would be you borrowed a stock and then sold that borrowed stock to another person. You later buy that stock in the market and give it back to whoever you borrowed it from. Someone who engages in short transaction is called a short seller. Continuing the baseball example, let’s say you borrow that card from a friend and then you sell that card for 10 dollars. The price of the card drops to 5 dollars, and you buy the card back from the store for 5 dollars. After you return the baseball card to your friend, you made 5 dollars of profit. Of course, if the price of the baseball card soars to 100 dollars, you are still required to buy that card back so you can return your friend’s property, in that case you lose 90 dollars.
With stocks, you are not borrowing from a friend, you are borrowing from the brokerage company. They want to be sure you can pay it back. If the price of the stock soars really high, the brokerage company is going to be worried that you don’t have enough money to buy the stock back. Therefore, they will initiate a margin call. When that happens either you deposit more money into the account or you have to buy the stock back immediately in the market and return it to the brokerage company. The sequence of a short squeeze would be, a margin call causes a bunch of short sellers to buy the stock. The buying causes the price to go up. The increasing price causes more margin calls to occur. As a result, more short sellers buy the stock, which causes the price to go up further, and so forth. The stock thereby goes up in a self-perpetuating loop. Gamestop was a heavily shorted stock, so when a bunch of people from the WallStreetBets forum bought the stock, that loop was initiated.
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Daniel and Eli
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