In the last few weeks, GameStop made headlines when the popular video game retailer’s shares skyrocketed after seeing a lot of activity from countless social media investors. In turn, all the activity ended up forcing hedge funds in Wall Street to cough up large sums of money.
How did this all happen? It’s a well-known fact that the shares for game companies alongside a few others like Nokia, Blackberry, and AMC theaters have always been very volatile. Thanks to a group on Reddit, however, this all changed. After much encouragement, a social media rally of stock purchases from those companies resulted in their values increasing exponentially.
Any good retail trader knows that it is never good practice to short the market, but it still happens. The act of shorting or short selling is a fairly simple concept. As an investor, we can borrow a stock, sell that stock, and then buy back these stocks before returning it to the lender.
The idea is to bet on the stocks being sold to drop in value. When it does fall after it is sold, as a short seller, we buy this back, now at a much lower rate. By the time we return it to the lender, we would have already profited from the entire process.
So when hedge funds notice businesses that make very little sense, they often decide to short sell their stocks. When they sell the shares, the prices of these stocks will drop, and then they buy it back for cheap. This was exactly what hedge funds were doing to GameStop. Unfortunately for them, lots of gamers and folks on social media thought to fight back.
They started buying up the stocks, causing the GameStop values to start going up. This led to the short sellers having no other choice but to buy at higher prices. This is what is known in the trading world as a short squeeze.
All the buying activity from short sellers at high values only aggravated the situation. The frenzied buying of shares simply caused the stock prices to soar even more to the point that the market craze peaked.
There are a million ways to make money in the stock market, but there is only one sure-fire way to lose it all quickly — and that is foregoing a stop-loss order when trading. When we enter a market we must always predetermine how much we are willing to lose. And whenever we fail to do this, we open ourselves up to unlimited risks.
Just as in the case with the hedge funds in the GameStop story, losing that much money in a single trade is not about poor strategy. Rather it is a clear indication of a risk management issue.
This scenario shows that anything can happen in the market and not having stops puts an investor at risk. To reiterate, the best way we can protect ourselves is by predetermining how much we are willing to lose. While we can sell what we do not own, it is never a recommended practice due to the unlimited risks that it brings to the table.