What has been going on with GameStop this week? This is the big question on everyone’s mind.
In this week’s podcast, Tom and Tim dig into the details about short-selling, trading stocks in margin accounts, hedge funds risk management, and how GameStop ties in.
Short-Selling, Margin, Risk Management & GameStop – Transcript
DISCLAIMER: Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.
Tom Mullooly: Welcome back to the podcast. This is episode number 342. I am Tom Mullooly and joining me today is Tim Mullooly. Hey there.
Tim Mullooly: Hey.
Tom Mullooly: Is there a way that we can not talk about GameStop and Robinhood and everything that’s going on this week?
Tim Mullooly: Not really. If we want to talk about the important things that are on everyone’s mind in terms of the market, this is pretty much consuming all of the headlines this week.
Tom Mullooly: It is the story. I think it’s important to know upfront that we’re not expressing an opinion on GameStop. We’re not recommending buying it or shorting it. And we also know that tempers are… They’re not even flaring, they’re raging.
Tim Mullooly: Right.
Tom Mullooly: Emotions are very high on both sides of the action surrounding this. And a lot of people are confused and upset and don’t understand what’s really happening. And so what we want to do with this podcast is talk a little bit about short selling. We want to talk about risk management. We want to talk about the plumbing that goes on behind the scenes at these brokerage firms, so clients really understand or get a better grasp of what’s happening with this.
Tim Mullooly: For anyone listening, we did a video about short selling this week. So you can watch that as well. But I think to understand where we are right now, you have to understand the basics of how we got there in the first place. So could you explain short selling for anyone out there? Because it’s not the traditional type of investing or trading that people naturally think of.
Tom Mullooly: Okay, I’ll start by saying that if you buy a stock, say you buy a stock at $7, what’s your risk in the stock?
Tim Mullooly: $7 could go to zero.
Tom Mullooly: Right, the stock could go to zero and you lose the $7. When you short a stock and it goes in the opposite direction, what’s your risk?
Tim Mullooly: There’s unlimited risk because you want it to go down. If it goes up, that’s bad for you.
Tom Mullooly: Right.
Tim Mullooly: But it could go up-
Tom Mullooly: Forever.
Tim Mullooly: Like we’re seeing with GameStop. It went from single digits all the way up to over 400. And it could go to, as they’re saying on Twitter, the moon. It could go to a million.
Tom Mullooly: So understand that when you are selling short a stock, your risk is unlimited. So let’s talk a little bit about the mechanics of short selling. And I’ll start by taking the opposite side. When you typically get involved in owning a stock, you buy it first, you sell it later. When you short sale, you are selling it first and looking to buy it back at a lower price later, because on both sides of these transactions, you’re looking to buy at a lower price, sell at a higher price. Typically when most people get involved with investing, they want to buy first and buy low and then sell in the future at a higher price. Short selling is just the same situation in reverse. So you’re selling the stock at a higher price, and you’re betting that you’re going to be buying it back in the future at a lower price. Still buying low, still selling high, just doing it in reverse order.
Tim Mullooly: Naturally, you buy your investment, you want it to go up. With short selling, you want your investment to go down in price.
Tom Mullooly: Correct. Right.
Tim Mullooly: So if someone is shorting GameStop, they want it to go down.
Tom Mullooly: Right. GameStop, like a lot of retailing companies, really hit the skids last year as the pandemic started to spread and the economy around the country was shutting down. And places like GameStop, where they’re located in malls and strip malls, there’s one not too far from my house in a strip mall, they’re having a tough time. And there was a research report that was put out a few months ago indicating that this stock could go to zero. That it may ultimately go under. The stock had been trading around the high single digits, $7, $8, $9, $10. I know it started this year, January of ’21, it started at $20 a share. And the bet was for people who read this research report, mostly money managers and hedge funds, read this report if they acted on it, they shorted the stock somewhere between $10 and $20. Maybe they shorted it at $7. But they sold it with the idea that this thing was going to zero or a lot lower than where it was.
Tim Mullooly: Do you want to talk about margin and how that factors in with short selling? Because I think that’s another important point to note about selling stock short.
Tom Mullooly: Yeah. It’s an education and I’ve learned the hard way with my own money, going way back into the ’80s about how costly these things can be.
Tim Mullooly: It’s counterintuitive for most people when you first hear about it. It’s like, “Wait, you can do something like that?”
Tom Mullooly: Yeah, right. You can sell something that you don’t own, and that is the entire premise with short selling. “I don’t own this thing. I want to buy it back at a lower price. So I’m locking in the sell price today.” Let’s get back to what I just said, that you’re selling something that you don’t own. All short selling is done from a margin account. You have to have a margin account set up at a brokerage firm. And what you want to do is whether you do it online on your own, or you’re doing it in a transaction over the phone with a broker… Like for us, we do block trades, we’re going to pick up the phone, we’re going to call our trader, and we’re going to say, “We’re looking to short 100,000 shares of X, Y, Z. What do you got for us?” What the trader now has to do is he’s got to find out how many shares are available to short at his firm.
Tim Mullooly: And they’re not always available.
Tom Mullooly: They’re not available. So why would they not be available? There may be a million shares of a stock like GameStop at a brokerage firm, but they’re not all in margin accounts. There’ve been a lot of folks online in the last 72 hours who said, “I don’t have a margin account. I’m not trading on margin. I have a margin account, but I pay in cash.” The problem is your securities are being lent out. Anything that’s in your margin account is being put up as a marginable security for the firm to use. And people get mad. They’re like, “Wait, I didn’t authorize that.”
Tim Mullooly: Yeah. That’s the thing. I think a lot of people are realizing, especially over the last 24 hours, especially with Robinhood, pretty much every account that you open at Robinhood is automatically opened as a margin account. Whether or not you use it as a margin account, like you said, they’re lending on those securities in your account.
Tom Mullooly: Right. So you may have a margin account. You may not be using margin to buy or sell, but your securities in a margin account are being used by your firm, which you authorized, they’re being used by your firm to… The technical term is you’re hypothecating these securities. I hate using words like that.
Tim Mullooly: Big word.
Tom Mullooly: But that’s what you’ve done. You have to lend these out. Now, when you’re borrowing stock on margin to sell short, you have carrying costs. So you’re paying interest on the margin balance that you’re carrying. And what happens now is every day, the margin department at your brokerage firm is calculating what your gain is or what your loss is on paper. How would you lose money in a short sale-
Tim Mullooly: If your stock goes up?
Tom Mullooly: If your stock goes up. So say you put on a short position at $15 a share, and the stock goes to 20, you’re now five bucks in the hole. Your margin department is going to tell you how much you’re in the hole. If you don’t maintain enough equity in your account, you will get a margin call.
Tim Mullooly: What’s a margin call?
Tom Mullooly: Okay, so a margin call is a requirement from your brokerage firm to put up more money in your account. Now there’s a couple of ways you can do it. You can deposit money, cash, into your account. You can add. There’s three ways to cover a margin call. You can put money, in the second way is to deposit more securities. Typically the initial margin requirement, I’ll get back to initial in a second, the initial margin requirement is 50%. So if you put in $10,000 worth of stock, you can take out $5,000 in cash, or you can use it to buy another $10,000 worth of stock, maintaining a 50% margin in the account. The third way to meet a margin call is to just sell stock in your account. The problem is you get a margin call when you’re down around 35% equity, which means you have to sell three times the amount of the margin call in stock to cover that margin call. For most people, when they get a margin call, it’s the end of the game. They’re getting wiped out.
Tim Mullooly: And that’s kind of what we saw earlier in the week and could potentially be seeing today on Friday while we’re recording this as well. The rest of the market is down, could be some forced selling to cover margin balances for larger institutions or just a lot of retail investors.
Tom Mullooly: Correct. Right. If your stock is not liquid or you’re in a losing position and you don’t want to recognize the loss and you still have a margin call… By the way, the margin call, usually if it’s not an urgent situation like what’s happening with GameStop, the margin department will give you a day or two or three to work out your margin call. There have been particular times in my experience where the margin call is, “You got to have money in your account, nine o’clock tomorrow morning.” It can get pretty intense. Understand that when a margin call is created, it’s not to protect you. It’s to protect the brokerage firm because they have extended credit to you and the asset that you’re borrowing against is losing value. This is a story about credit risk. That’s really what this is about. And for folks who listened to this podcast all the way back to episode one, episode two, episode three, I talked about what happened in 2008 was just a gigantic margin call. This is the same thing happening on a smaller scale with GameStop.
Tim Mullooly: Right.
Tom Mullooly: And maybe with a few other stocks as well. It’s important to understand that the initial margin requirement, as I mentioned earlier, is 50%. firms have the ability and you give them that ability to change margin requirements as market conditions change. And so there’s going to be periods of time where a brokerage firm may say, “This stock is no longer marginable.” Now, if you own it in a margin account, what happens? You lose buying power. You may have a margin call because you don’t have the buying power that you used to have. So there’s a lot of problems.
They can change these margin requirements on a daily basis. And this happens, by the way, on a daily basis in the commodity market. Frozen orange juice starts trading outside its typical daily band, the exchange where the options are traded or the futures are traded, they are going to change the margin requirements. Get used to it. It’s the way it is. There will be times, past and present, where margin requirements on stocks will change. So the initial margin requirement for most stocks is 50%. You can go down to 35% before getting a margin call, but there will be times in extreme volatility where the margin ability of the security just goes away.
Tim Mullooly: Can we talk about why short selling and margin isn’t something really that we do here for our clients and why it’s not something that we employ in our strategy?
Tom Mullooly: Well, I’ll editorialize that a little bit by saying I’m offended when I see all these news stories that talk about investors being harmed. Understand, if you are working on margin, you are not investing, you’re trading.
Tim Mullooly: Speculating.
Tom Mullooly: That’s exactly what you’re doing. You’re speculating. And so this is pure speculation and it’s why we really don’t get involved in this anymore. I will tell you that if you knew me in a previous life, as a broker, that was a lot of what I did. And learned, unfortunately, the hard way, as I mentioned earlier, with my own account and wiped myself out a couple of times speculating, trading on this. So we do little to none of this kind of work with our clients and our portfolios. But it does raise the question of if you’re a money manager or a hedge fund manager and you put on a short position, and these guys manage risk for a living, I got to believe that they put on collars that say, “Hey, if we shorted this stock at $20 and it gets 10% away or 15%, or even 20% away from our position, we are required to close out that position at a loss.” And so the story on GameStop in the last two weeks was that there was a gigantic short position in this stock. I wonder how many professional investors, are still short the stock? Because the stock has essentially gone from $7 a few weeks back, to $300, $400 a share now.
Tim Mullooly: Yeah. There are a lot of details that aren’t being considered about how these hedge funds manage their risk.
Tom Mullooly: And honestly, it’s none of their business. It’s no one’s business because we don’t talk about what we’re doing with our client’s investments. We would expect that hedge funds would take the same kind of approach. “We’re not going to tell you what we’re doing. We’re only going to announce when we’re required to announce.” If we acquire 5% or more in an investment, we’re required to file a 13F. Anything more than that, I don’t think it’s anybody’s business. And so you look at this and say, if you’re a professional or hedge fund and you put on a short position at $20, and now the stock is $30, you almost have an obligation to close that out, which leads to a short squeeze. This is really important. One of the terms I picked up early in my career is that the shorts are always wrong. I think “always” is a strong term, but I would rephrase that by saying the shorts are usually wrong.
Another phrase that I learned very quickly in my career is that short selling is rocket fuel. I don’t think people have really thought this through. But suppose you’re involved in a thinly traded stock, there’s not a lot of volume in GameStop normally, you’re shorting the stock very quietly, you build up a large short position in it, you’re betting on this thing to go down. When the stock starts to move away from your price and you’ve decided we’re going to close this out, it’s a loser, we’re not going to work on it anymore, we’re going to have to buy it back, what are you basically doing? The stock has moved up, so you’ve lost money. Now you have to go in and buy the stock.
Tim Mullooly: Which ultimately forces it to go higher.
Tom Mullooly: Even higher. Right.
Tim Mullooly: You’re doubling down on the fact that your bet was wrong.
Tom Mullooly: That’s right. And that’s how you get involved with a short squeeze. And so we saw a lot of folks on these message boards on Reddit talk about how we should buy the stock and don’t plan on selling this thing, because then everyone who’s short is forced to go into the open market and buy the stock. And if there are no sellers and there’s a lot of buyers, price has to go up. So back to that supply and demand story again.
Tim Mullooly: Right? And I think the Morgan Housel wrote a post this morning or yesterday about how things can happen, it gets crazier than people expect. And he was talking about this. He also related it to how species of animals go extinct, they go a lot quicker than people expect. It starts slow. The exponential growth sometimes smacks people in the face with how seemingly overnight things get out of control.
Tom Mullooly: Right.
Tim Mullooly: He pointed out, the message boards on Reddit had been talking about GameStop for almost over two months now. It first started with a few people and then it got the attention of more people. And then just in the last 72 hours, you see how these things can take off. And that is something that a lot of people don’t expect, including hedge funds and professionals, you can’t see it coming sometimes. And like we said, the risk there is unlimited if you’re shorting or using margin in general. So it makes it even, like you said, rocket fuel, it makes it even crazier to participate in.
Tom Mullooly: And so that’s part of the reason why we’ve seen this exponential rise in the price of GameStop. So if you’re with us so far, I want to introduce another term into this story. And that is called naked short selling. Earlier in the conversation I had mentioned that when you want to short a stock, you have to call your trading desk and find out how many shares are available for short. But the actual conversation is the trader asks you, “How many shares do you want to shorten?” And they’ll tell you yes or no if the shares are available. So it turns out, according to some reports, there may have been a short position in GameStop of something close to 130% of the available shares outstanding, which is theory impossible.
Tim Mullooly: Shouldn’t happen.
Tom Mullooly: Yeah, that should not happen. When you see, as I mentioned in the video, when you see companies that have a large short position, and that could be 30%, 40%, those are large short positions. When you see a stock that’s got 130% short, something’s going on here. Now, remember, you’re picking up the phone as a hedge fund or money manager, and you’re calling your desk at your brokerage firm and you’re saying, “I want a short, 10,000 shares of this stock. Is it available to short?” They will tell you yes or no. Is that the fault of a hedge fund manager?
Tim Mullooly: No. I was just going to say, I feel like it’s negligence, whether intentional or unintentional on the broker who is telling them that these shares are available without checking. Yeah, you can’t really fault a hedge fund in that scenario.
Tom Mullooly: Right. I also think that, I don’t know, nobody knows for sure what the fair market value is of a company like GameStop, I don’t think it’s $7, but I don’t think it’s $385 a share like it is right now.
Tim Mullooly: Right.
Tom Mullooly: So I’m just spit balling, just thinking out loud, I wonder if this is a good short right now at these kinds of prices.
Tim Mullooly: Right. That’s what professional traders are probably kicking around as well, because the way that it has exponentially grown, you don’t expect it to stay at these levels forever. And how much higher can it realistically go?
Tom Mullooly: Yeah.
Tim Mullooly: That’s the debate that these people are probably having. And then if they want to put on another short position to bet that the bubble is going to burst in a sense at some point soon, then they can ride it on the way down and be correct.
Tom Mullooly: So in the time that we’ve got remaining, I want to just address this whole Robinhood thing. And so Tim, you mentioned earlier that the default setting for when you open a Robinhood account on your phone… Robinhood is an app, so it’s unlike the old days walking into Merrill Lynch and filling out a paper application. So when you sign up for an account at Robinhood on the app, on your phone, you are immediately defaulted into a margin account. Now, Robinhood is a broker. They don’t execute the stock orders themselves.
Tim Mullooly: They’re a middleman.
Tom Mullooly: They are. And understand that Robinhood does not charge any commissions. So how does a firm like Robinhood actually make money?
Tim Mullooly: That’s the thing. And Brendan said it the other day, if the product is free, you are the product.
Tom Mullooly: You are the product.
Tim Mullooly: The individual user is the product.
Tom Mullooly: Yeah.
Tim Mullooly: And we’ll explain what that means.
Tom Mullooly: So what Robinhood does is they batch their orders and they will place the trades with another broker. One of the biggest ones out there is a firm called Citadel Securities and they handle the actual buying or selling for Robinhood. Don’t misunderstand that those two companies are not connected in the sense that neither owns the other. Citadel works with all brokerage firms. A few years ago, Citadel’s biggest customer was Charles Schwab. So what happens is this is called payment for order flow. And so Citadel will actually pay Robinhood for them to send Robinhood orders to Citadel. And so that’s what Tim was just alluding to is that Robinhood makes money by sending your order that you placed on Robinhood through Citadel. Okay?
Now the problem that you run into is that we have trade date plus two settlement on all stock transactions. Meaning if you buy something on Monday, the trade actually settles, meaning the stock has to be in the account, the money has to be transferred, that happens on Wednesday. So you do a trade on Monday, it’s due on Wednesday. You do a trade on Friday, it’s due the following Tuesday in the account. Now when I got started, it was trade date plus seven, and then it became trade date plus five. And we’ve been going shorter, shorter, shorter, shorter, shorter.
Tim Mullooly: It was three when I started.
Tom Mullooly: Okay. Trade date plus three.
Tim Mullooly: So in the last six years, it’s gone from three to two.
Tom Mullooly: Yeah, eventually it’ll be trade date. Yeah, it’ll be what they call European settlement. And it’ll be the money has to be in the account today, which I think will actually slow down volatility in some of these markets. So understand that a brokerage firm now has trade date plus two business days to either move the shares or get the money in the account. And if you’re doing it on margin, these stocks are moving up, down, sideways all throughout. So they have to maintain margin requirements and they’ve got to deliver cash to the other side of that trade. So you’ve got credit risk. This is really about credit risk. So the National Securities Clearing Corp, they manage the credit risk for all brokers. So what they do to mitigate the risk is that these brokers have to put a clearing deposit with them.
I think a lot of people don’t really understand that. And this clearing deposit that they have to have on hand, it’s basically cash to cover the trade, was put in place by Dodd-Frank after what happened in 2008. And so these are good things. These guardrails are good things that were put in place from Dodd-Frank. But I am going to editorialize for a moment and just say, it’s hilarious to see people in Washington, DC, railing against how Robinhood is screwing their own customers. No, it’s actually, they’re abiding by the rules that were set up by you guys in Washington by Dodd-Frank. So if a brokerage firm were to ever fail, NSCC would put up money. The other members of NSCC, all the other brokerage firms, would put up money to make sure that all the trades go through. And then you’ve got this mark to market risk.
And if you watch the videos or the podcasts from post 2008, we talk about how the accounting standards board, FASB, changed mark to market rules on March 6th of 2009, March 9th of 2009 was two days later, incidentally, was the bottom of the market, we’ve gone pretty much straight ups from there. And so mark to market, very big deal. But what we’re talking about now is GameStop, which was a huge position at Robinhood. Used to trade… Let’s just say traded between $20 and $30 a share. So you have this mark to market risk. And that’s something that a brokerage firm like Robinhood could manage, because they’re basically trying to gauge, “How much margin do we have to keep at NSCC to stay within the rules?” But how much margin do you have to put up when your stock now swings between 150 a share and $400 a share? You got to put up way, way, way more margin just to cover the trades that are going on.
And so you may be in a situation where you got orders canceled at Robinhood, each individual situation’s a little different, but there’s a lot going on plumbing wise underneath the surface that I don’t think a lot of people even stopped to consider. A lot of moving parts. There’s a lot more to the story. Actually, very little of it nefarious or evil. It’s really just margin requirements and managing credit risk so that your brokerage firm doesn’t fail and your account won’t get frozen for months as it switches from one firm to another. So a lot going on. If you’ve got more questions about this or want to discuss it, get in touch with us. But that’s going to wrap up episode 342. Thanks again for tuning in.
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