What happened

Shares of Chinese online-education company GSX Techedu (GOTU 1.00%) are like a snowball rolling downhill. As of 1:30 p.m. EDT on Friday, the stock was down 13%. And it's now fallen about 40% from highs reached earlier this month.

Nothing really happened on Friday to explain the drop. But if you consider GSX Techedu's journey so far this year, it's not terribly surprising to see the stock fall.

A grizzly bear is growling against a black background.

Image source: Getty Images.

So what

GSX Techedu is the center of a controversy. Research firms have accused the company of fraud. Here's a quick recap:

  • April 14: Citron Research calls the company "the most blatant Chinese stock fraud since 2011."
  • May 18: Muddy Waters Research says it's "a near-total fraud."
  • June 2: Grizzly Research issues a report presenting what it calls "smoking gun evidence of fraud."

From there, the stock reacted in the most unpredictable way: It rallied. From the Citron report, it went up over 300%. A rally suggests bullish investor sentiment on the surface. But looking deeper, many investors believed the bearish reports. Short interest for GSX Techedu (people betting against it) surged.

GSX Chart

GSX data by YCharts.

With short-selling, brokerages require investors to maintain enough funds to cover their positions. But when a shorted stock rises, this increases the amount of money investors need to keep in their accounts. That's a problem for the shorts. Failure to deposit more funds results in brokerages closing short positions.

As the above chart shows, short interest in GSX Techedu stock began to fall as the price per share began to increase. Therefore, it's possible short-sellers still believed GSX Techedu was a fraud. But they were forced out of their positions by brokerage requirements, leading to a decline in short interest. And as they covered (by purchasing shares), it only caused the price to spike higher still, squeezing out more of their short-selling peers.

Perhaps the stock is falling recently because this behind-the-scenes problem is finally working itself out.

Now what

I'm not saying GSX Techedu is a fraud; I have no idea. I personally find both the fraud reports and the rebuttals from GSX Techedu management reasonable. Without insider information, I'm left on the sidelines to simply wait for the truth to be firmly established one way or the other. 

This whole situation reminds me of why buying stock in great companies and holding for the long term is the safest strategy for making money in the market. If GSX Techedu is a fraud, those who shorted the stock in April and May were correct. Yet it's possible some still lost money covering their positions at higher prices due to brokerage requirements. Again, they were right but still lost money.

That's why I take cash that I don't plan on needing for the next three to five years and invest in stocks. It greatly reduces the downside risk that comes with more-complicated strategies like short-selling. I can keep holding for years, waiting for my investing thesis to play out.