Few stocks have garnered the level of attention that GameStop (GME -0.68%) has so far in 2021. The video game retailer has been on the outs for a long time, threatened by shifting industry trends and the move toward digital distribution of video games. That prompted many institutional investors to bet against GameStop's survival by selling the stock short .
But as those investors learned the hard way, short-selling is fraught with peril. Even when a stock's underlying business remains weak, the ever-present possibility of a short squeeze can bring massive losses. Indeed, as much as GameStop short-sellers have lost as of Feb. 16 from betting against the company, it's only a tiny fraction of how bad their losses would've been if they'd been forced to close their short positions just a couple weeks ago.
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On the first trading day of 2021, GameStop's shares cost $17.25
Coming into the new year, GameStop had seen its stock jump. The share price had tripled since September, as investors got excited about a potential turnaround. Activist investors bought up a 10% stake in GameStop and then proposed a big change in corporate strategy. By moving into e-commerce, they argued, GameStop could staunch the bleeding from its failing brick-and-mortar retail business and focus on a business model with at least a fighting chance of long-term success.
Indeed, in early December, GameStop management predicted that the company would start growing again in the fourth quarter. Introductions of new game consoles would finally lift the video game specialist out of its slump.
Yet many were still skeptical about GameStop's chances of turning things around. After all, it has lots of e-commerce competition, and it was far from clear that GameStop would command any brand loyalty in online sales.
The big squeeze
What happened next was an amazing story. GameStop became the favorite stock of individual investors on the Reddit forum WallStreetBets, which hoped to take advantage of the massive short interest in the stock. After these investors urged others to buy and hold positions, the price of GameStop stock rose dramatically.
That started a cascade effect known as a short squeeze. Those who'd sold GameStop short were losing huge amounts of money. Many of them chose to cut their losses by buying back the stock to cover their short positions. That buying pressure pushed share prices still higher.
Shares of GameStop topped out at $483 per share. Short-sellers who had taken a $10,000 position on Jan. 4 would've been underwater by $270,000 -- a truly massive hit.
Clawing back their losses
Short squeezes aren't sustainable, however. It was inevitable that GameStop stock would fall back to earth. Within days of its top, the share price had plunged to just over $50 per share. GameStop closed on Feb. 16 at $49.59.
Those short-sellers who held their positions the whole time would still have big losses -- around $18,750 based on the Feb. 16 closing price. But $18,750 is obviously just a tiny fraction of $270,000. If GameStop keeps falling, then short-sellers could end up earning back more of what they lost.
Beware of short-selling
The problem is that many of those short-sellers never got a chance to hold on. Many brokers would have automatically closed short positions once investors no longer had enough money or margin capacity in their accounts to cover those losses. Those short-sellers got closed out at the worst possible time, and then watched in horror as the stock price finally moved back downward, too late to help them.
There are two key lessons for investors here. First, the good thing about being a shareowner rather than a short-seller is that you can never lose more than you invest in a stock. Also, as long as you don't trade on margin, stockholders always have control of when they want to take profits or losses by selling out of their position. If you're going to sell a stock short, remembering that you don't always have control is critical to avoid costly mistakes.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
