Amazing facts: Short-selling and the illogical stock market

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AMAZING FACTS: SHORT-SELLING AND THE ILLOGICAL STOCK MARKET

By Rose Lane

Short-selling is a stock market tactic wherein investors will “borrow” a stock and sell it when the price of that stock is falling from a high position, with the intention of buying it back when it begins to rise again from a low position. This method of investment reaps profit from an asset’s stock price decreasing – as opposed to a “long” method of investment referring to buying stocks and holding them until they grow in value, profiting from their price increasing.

While short-selling may seem like just one stock market tactic in a numbers game, investor actions affect whole companies and even whole markets. Shorting on this scale may mean benefiting from the downfall of a business or the upending of people’s lives.

Anthony Elgindy spent seven years in prison for encouraging shorting

Anthony Elgindy was an early voice on investment, becoming a stock trader in 1988 and a short seller in 1995. In 2001, he wrote a personal website update informing subscribers that the chief executive of a company named Nuclear Solutions – Paul Brown – was a “convicted felon”. Elgindy later shorted Nuclear Solutions stocks and recommended that his subscribers do the same.

As it turns out, Brown was not a convicted felon, and Elgindy was soon taken to court. In 2002, he was indicted for racketeering, securities fraud, extortion, and other crimes – having been found guilty of conspiring to short other companies the same way. He was later sentenced to 11 years in federal prison, of which he served nearly seven.

US Attorney Alan Vinegrad called Elgindy an “experienced stock manipulator” in court, while the National Association of Securities Dealers (NASD) ruled that he “engaged in a manipulative scheme…selling the stock short at the artificially high prices, and then taking active steps to depress the share price” to eventually make $US66,000 in illegal gains.

Michael Burry made millions from the Global Financial Crisis

In 2005, Scion Capital hedge fund manager Michael Burry began to suspect that the United States housing market was subject to high levels of inflation as new homeowners were offered high-risk loans.

The housing market was later labelled an asset bubble, meaning the price of housing rose at a rapid pace without the underlying fundamentals to justify it – a major cause of the financial crisis in the US.

In response, Burry created a new financial system called a credit default swap, which allowed investors to offset their credit risk with another investor by having them agree to reimburse if the borrower were to default. This system allowed Burry to short the housing market.

Burry sold credit default swap positions on the assumption that housing prices would drop when the bubble burst. The housing market crashed in 2008 and his borrowing investors cashed in for nearly 500% returns, all while 10 million Americans were displaced.

Reddit users prevented investors from shorting GameStop

In an event later named The GameStop Short Squeeze of 2021, users of the online chat forum Reddit caused major hedge fund managers significant losses by protesting investor shorting of the video game retailer.

Melvin Capital and other hedge funds took a short position on GameStop, selling their stocks in the company on the prediction that it would fail and thus prices would drop. When Reddit users noticed this, they launched a co-ordinated stock-buying spree to raise the GameStop stock price, punishing the hedge fund managers for short-selling.

This particular punishment is called a “short squeeze”, wherein the short-selling investors must start re-buying their stocks at a higher price than they sold for, and drive the stock price up even further in the process. The stock market value of GameStop surged to more than US$24 billion by the end of January, 2021.