Monday, February 01, 2021

Shortsellers are neither evil nor mathematically impossible

And if you weren't a brainwashed imbecile, you would occasionally be a shortseller, too



The GameStop mania is a religious movement involving millions of staggering and overwhelmingly young idiots who believe that

* shortsellers are extremely evil and to fight them, you have to sacrifice everything
* they are doing something that doesn't even mathematically make sense
* by panic buying a shorted stock for a price that is overstated by a factor of 10-1,000, all the participants are going to make astronomical profits

This kind of stupidity just leaves me utterly speechless (by the way, I am instantly banning every commenter who shows any inclination to believe either of these amazing propositions because interactions with creatures who are this dumb simply terrify me and I won't allow the comment sections to become unfiltered cesspools).

The situation is probably even worse than it seems. According to a Harvard College Consulting Group research, 31% of U.S. "investors" below 24 want to make a "quick cash" (I immediately imagine the "lawyer" from Idiocracy who said that he liked money) and about the same percentage (around 30%) use Reddit as a recommendation what to do. The number of registered users of WallStreetBets sub-Reddit grew from 3 million to 7.7 million in a week but a much larger number of people follow the forum without any registration.



Great. So what is going on with GameStop Corp (GME)? It is an unspectacular corporation (with shops where you can buy PC games on increasingly outdated media) with 69,746,960 shares outstanding. I will call the number 70 million, it will clearly change absolutely nothing. The stock price was decreasing from $30 in 2016 to $4 or so during the bottoms of 2019 and 2020 and then it had a tendency to grow towards $20 at the end of 2020.

What is the right price you should pay or get for a stock? This is the question that every sane investor is trying to carefully answer. He is generally buying the stock that costs less than the fair or sustainable price; and selling when the current market price is (much) higher than that. This is how he makes a profit if he is right.



In healthy conditions, the investors collectively drive a stock price to a number that rarely changes by 10% – the precision of their hard work is typically better than 10% although this precision is often shown not to be an actual "accuracy". But 10% is a big deal. This company has some $500 million in cash (if you divide it by 70 million, you get $7 per stock) and produces some $60 million in profits per year (almost $1 per stock). You may imagine that the company is worth the cash plus the profits per 10 years. At any rate, you will get something in the interval $5-$20. When the stock was worth almost $20, a shortseller decided that it was already overvalued, so they shorted it. The text below will also explain what this verb means.

At any rate, the high-precision trading has been totally liquidated for this stock because a horde of millions of mindlessly objedient, brain-dead "investors" controlled by the puppet masters at Reddit has arrived to (mostly) Robinhood and started to panic buy GameStop at any price, and drove the price to over $300 per stock (the stock price already reached almost $480, too; there have been clear day-long cycles that an intelligent trader could derive a profit from). Some shortsellers that made bets on the decline of the price registered multi-billion losses, some of them could have locked the losses (larger losses than the profits they were planning to make because the stock price could have only decreased by $20 but it grew by over $300). But the shortsellers as a whole obviously aren't losing anything and won't lose this battle – assuming that the basic laws will be respected.

How shortselling works

As I said, GameStop has 70 million shares outstanding. It means that each stock represents 1/70,000,000 of the company. You may get the corresponding fraction of the profits in the form of dividends – those were about $0.38 per stock per year. If you can multiply by 70 million, you will be able to calculate that $26.6 million were paid in dividends in each of those years.

A regular, long investor may have 1,000 GME stocks. His broker app is showing him that they are worth about $325,000 now (because one stock is $325). That's a big increase from a few thousand which is what he paid for those stocks if he bought early (most investors didn't because most owners of GME already bought in recent days). OK, one person with a positive number of stocks may sell the stocks to another person who has a non-negative number of stocks and some of the people, including the brain-dead sheep, understand the positive integers.

But none of them understands negative integers. In recent years, schools no longer taught any real mathematics (or any subject with substance); instead, they are making sure that the "students" grow into brainless sheep parroting outrageous and silly lies about the discrimination of minorities, climate change, and similar toxic garbage. Those who still understand the negative numbers know that there is absolutely nothing mathematically strange about negative numbers of stocks and shortselling and those are actually crucial ingredients of healthy and effective modern markets.

How a shortseller is created? Imagine that there were no shortsellers when GME was worth $20. The first soon-to-be shortseller came to a trading platform, placed $1 million dollars over there (that was the initial value of his holdings at the platform), and bought a small number of (positive) stocks (OK, I will assume that he didn't have any other stocks, to make it simpler). But he also sold 1,000 GME stocks. How could he have sold 1,000 stocks if he hadn't have any? Well, easily. He just went from "0" to "0 minus 1,000" stocks which means that he ended with "-1,000 stocks". Is it a problem for you?

If it is a problem for you, it is just your severe mental limitation, not a problem in mathematics, because all the formulae continue to work perfectly. Like their positive friends, negative numbers may be added, subtracted, multiplied, and divided, and the distributive and similar laws continue to hold! ;-) He had to pay minus $20,000 for those minus 1,000 stocks – which means that he actually ended up with $1,020,000 in cash, more than what he started with. But he also owns those minus 1,000 GME stocks – which means that he owes 1,000 stocks to someone (who will remain anonymous). If he wants to leave the trading platform, he has to liquidate all these positions i.e. turn all stocks (including negative ones) to cash. So he has to buy the stocks back to return from negative numbers to zero. But now, his trading app shows
Your holdings:

minus 1,000 GME stocks; worth –$20,000
$1,020,000 in cash
Total: $1,000,000
What happened after the horde of brainless sheep drove the price to $325 by panic buying? The app suddenly showed:
Your holdings:

minus 1,000 GME stocks; worth –$325,000
$1,020,000 in cash
Total: $695,000
Look carefully. The cash didn't change – it remained $1,020,000, from the original one million plus $20,000 from the stocks he sold at the beginning (he shortsold them which means simply selling and going to a negative number of stocks). But because one stock is worth much more, $325, and he owns a negative number, the total value of these negative stocks "grew" to a larger negative number. He still owes these 1,000 stocks – he needs to buy the stocks back before he leaves the trading platform. In total, the wealth dropped from the original $1,000,000 to less than $700,000. Bad.

But this particular investor hasn't gone through any cataclysmic event yet. The broker sees that this shortseller got poorer but his total holdings are still positive. It is still possible to close all the positions (i.e. buy those 1,000 stocks back) and end up with a positive amount of cash which he may take away. So the broker allows the shortseller to exist in this situation. However, the broker needs to violently close the positions (i.e. buy back the stocks – convert the negative stocks to cash) at the moment when the total holdings of the shortseller would go to zero and then possibly to negative numbers. Otherwise the shortseller would owe something to the broker and the broker wouldn't be sure that he gets the debt back. This moment of "forced closure" of the stock positions is called the "margin call". Someone from the broker will probably call the shortseller by phone and inform him about the trouble.

In practice, the positions are automatically closed before the total value of the holding reaches zero because the shortseller has his own panic button: when the price goes in the undesirable direction (which means up, in the case of a shortseller) and reaches some critical line, the stocks are sold automatically because the shortseller has instructed the platform to "insure" him in this way. This closure that takes place because the investor has planned it as a sort of insurance is called "stoploss" (it may exist for long positions, too, and the stoploss selling of stocks is activated when the stock prices drops too low, to a predetermined level).

In both cases, the margin call and stop loss, the shortseller ends up buying the stocks back – at a moment that he couldn't plan. This extra "demand for stocks" (he needs to buy, to get from minus 1,000 to zero) is driving the stock price up. When he buys a lot, it creates a "short squeeze". The stock price may grow a lot after the stoploss or margin call, especially if the supply of stocks is very limited. The GME Reddit sheep are apparently hoping that such a short squeeze will turn millions of these sheep into billionaires and, after someone will tell them what to do, and they will collectively move to a paradise. Well, that's not what will happen. But before we discuss the non-existence of paradise, let's ask once again:

How was the short (negative) stock position actually created?

Well, it's easy. Our shortseller who came to short 1,000 stocks was simply selling 1,000 stocks (even though he didn't have any). What did the broker do? Well, the shortseller was an actual seller so the trading platform had to find a matching counterparty, a buyer. It could have been several people who divided those 1,000 stocks but let's assume there was one person. Fine, so one person, Mr Long, bought 1,000 stocks (and he had at least 1,000 stocks after the transaction because we assumed that there were no shortsellers before our first Adam the Shortseller) while Adam the Shortseller sold them. The trading platforms don't tell you the name of your counterparty but in principle, those exist and you could learn about them.

Let's assume that Mr Long didn't have any stocks before the transaction, either. So Mr Long has 1,000 stocks while Mr Adam has minus 1,000 stocks. In total, they possess 0 GME stocks. The broker has a simple job: it just multiplies the current stock price by +1,000 or –1,000 to show how much wealth is stored in GME for these two men. These two numbers only differ by the sign; their sum is zero which means that the broker has no exposure to the stock (the broker is just administering the opposite bets by two men).

OK, it's simple. Before Mr Adam is forced to buy back the shares (stoploss or margin call), and he surely hopes that it will never happen, the GME-related holdings of these two men are simply two numbers that add to zero, these numbers are shown by the trading platform, and the trading platform has no net position. However, there are also special moments, the dividends and shareholders' meetings.

Dividends and shortsellers

We said that in 2019, GME paid $0.38 per stock in dividends. Let's assume a similar moment arrives. Well, Mr Long has to get $380 in dividends for his stock; this is the pre-tax number and he may get the lower, after-tax dividends immediately. Where does this $380 come from? If he held a regular stock, the money would come directly from the corporate headquarters. When he has a long position that was created by matching a short one, the flow of the money is even simpler. The dividend is paid by Mr Adam, the shortseller. Instead of getting the money, the shortsellers must pay the dividends. They pay the dividends to the broker which moves those $380 to a long position holder. In general, the broker doesn't need to distinguish "which banknotes belongs to whom". It just has some funds collected from the shortsellers; and this package is also used to reimburse the long investors (who have a positive number of stocks). The shortseller has to pay the pre-tax dividends but he may also consider this payment as expenses of a sort (for tax purposes) which will reduce his tax at the end. Which kind of expenses is a technical question.

So it is really simple. Mr Long and Mr Adam have the opposite fate of the holdings – when one goes up, the other goes down, and vice versa – and they are doing the opposite things at the moment of the divident payment. The broker is just administering this game, these two opposite bets.

What about the voting rights?

Everyone who owns a stock should have a vote at the shareholders' meeting (where a majority decides about important changes in the company). If you have (positive) X stocks, you should have X votes. How does it work? In our example, 70,001,000 stocks were in positive positions while 1,000 were negative ones. The sum is 70,000,000. Did the denominator, the total number of votes at the shareholder meeting, become 70,001,000? The shortseller is obviously a "company hater" and should have a negative amount of votes. Does it make any sense? No, it doesn't. But the positive 70,001,000 stocks could share the 100% of the votes.

It could be organized in this way and the system would work well. But that's not how the voting rights are defined by the laws (plus rules of most companies). Instead, the denominator is always 70 million. There are the "real" 70 million names assigned to each of the 70 million stocks and these owners are remembered in a database. Mr Adam clearly isn't among them because he's short. But there are also corresponding 1,000 positive stocks that don't have voting rights, either.

In fact, if you agree to have a margin account where it is possible to short stocks (and those need to exist if someone wants to go short; and they also need to exist when someone wants to harm the shortsellers – he needs to play against them!), you also agree to be stripped of the voting rights on a stock even in some cases when your position is long (positive number of stocks). A margin account is one where the holdings may be positive or negative and where the collateral (the margin, like our original $1 million) is needed to keep the account open. Almost no one cares because people generally own the stocks for the money (dividends and capital gains), not for the voting rights. But if you really care how it is determined which long holders of stocks possess the voting rights and which lose them (because those stocks are matched to the short positions), see e.g. Investopedia. It may be a bit complicated but be sure that all these algorithms are fully automatic and well-defined. 70 million (long) stocks have voting rights while the remaining long (positive) stocks and all the short (negative) stocks carry no voting rights.

Nirvana coming

Right now, over 100% of the stocks of GME are shorted. It means that instead of 70 million outstanding stocks, people possess some 140 million worth of long stocks; and 70 million worth of short stocks. The stock price after Friday was $325 per stock which means (multiply the stock price by 140 million or 70 million) that the overall value of the long positions is some $45.5 billion and the overall value of the short positions is minus $22.75 billion.

The overall "paper loss" of the shortsellers (which hasn't been fully locked yet) is smaller than those $22.75 billion. If all of them opened their short positions at (near) zero prices of GME, $22.75 billion would be the not-yet-realized loss of the shortsellers. But none of the shortsellers shorted the stock when it was zero; and in fact, almost all of them shorted the stock when it was already comparable to the current price. So their "loss so far" is much smaller than $22.75 billion and they may actually be in black numbers.

It's possible that Melvin or Citron, some big shortsellers, were forced to close their positions and they locked a multi-billion loss. They didn't expect that a herd of millions of braindead sheep would run to their field, start GME panic buying, and inflate the stock price that should be $5-$20 to more than $300. For this "sin" of assuming that we don't live in a world where millions of braindead sheep freely run and destroy everything they touch, they may have paid dearly.

However, Melvin and Citron aren't the only shortsellers. They shorted the stock (sold the stock, starting from zero and going to negative numbers of stocks) when the stock was worth some $20. That was a plan to make a profit assuming that the stock price would drop well below $20 which is when they would close the short position, making a profit. A stock price much above $20 would mean the closure of their whole position (which would also burn the cash that was used as a collateral; that $1 million in my example above).

But now the situation is vastly easier and safer for shortsellers – which may be you and which should be you. You may prepare a strategy to register a temporary paper loss but in a foreseeable future, the stock price will drop well below $325, you close your short position, and make the corresponding profit. So be sure that billions of new dollars are being pumped into this trade as a collateral for new short positions. And if you asked me to make a guess, I actually think that some other, larger and safer, hedge funds have simply bought the short positions from Melvin and/or Citron under some conditions (probably not far from the current market prices), and that is why you couldn't see any dramatic dynamics from a short squeeze (the owner of the big short position was changed without affecting the Robinhood market). With a generous collateral, this new owner of the short position may very well withstand a temporary uptick of GME to thousands of dollars.

A new shortseller – which may be another hedge fund but it may be you, too – puts a collateral to his broker account and for e.g. minus-one-quarter of it, he shortsells the GME stock. With some mathematics, you may see that he may keep this position open up to the GME stock price around $1,000. OK, numerically: he places $1 million in his account, shortsells 770 stocks per $325, and his cash goes to $1.25 million while he owns minus 770 stocks (owes 770 stocks). Everytime the GME stock price goes up $1, his total holdings go down $770 so the stock price needs to go up by $1 million/770 = $1300 for his total holdings to be zero. So he may take the risk and assume that the GME stock price will never surpass \[ 1,300+ 325 = 1,625 \] dollars. He will be in a big temporary loss and anxiety if the GME stock price gets closer but eventually the long buyers run out of money, the excess of demand of the stock over the supply evaporates, people realize it, and the stock price starts to drop, ultimately below (and well below) $325 again. That's when the shortseller closes the position, registering a nice profit. Millions of Reddit users will have bought CME stocks around $300 but they will only be able to get vastly less for the stock.

The shortseller's risk is nonzero because the loons may pump the GME stock price well above $1,600, too. Every short position carries a nonzero risk. But the higher the price goes, the smaller the risk is. In fact, the sophisticated shortsellers – often the hedge funds – do much more. They surely calculate or estimate how much more money may flow into the stupid sheep's long positions and how much more money the sane people will be able to use for the collateral for the opposite positions. This whole game is a tug-of-war and the side with the greater total amount of money wins. Of course the GME stock price will ultimately collapse well below $325 and probably close to the $20 before the insanity started.

It may take a day or a month, it is rather hard to predict. But at that moment, the number of short positions may be huge. 770 million stocks will be long while 700 million are short; the sum will still be 70 million. Instead of $45.5 billion (search above), the long position holders may posses $300 billion at some future moment. Or it may be a trillion if both the short interest and the stock price go up hugely. Of course, they will start to sell, to lock the profits or minimize the losses because it will be hard to pump the price further. Collectively, the long position holders will own $300 billion in a company whose value is still comparable to $1 billion (it is effectively worthless, in comparison with the money in this game).

So I think it's obvious that the shortsellers – not necessarily big institutions but even intelligent small people – will ultimately win. When they do, other bubbles may be deflated as well because the set of "imbeciles buying GME for $300" and "imbeciles buying TSLA for $880" or "imbeciles buying the Bitcoin for $33,000" are hugely overlapping sets. The number of similar idiotic campaigns that compete for these idiots' money has grown rather large.

But I am terrified by the political power of the GME long idiots and what it means for the future of capitalism and mankind. It seems like those 7.7 million people who are registered at WallStreetBets all think that it is a great idea to buy a $10 stock for $300 or more. Great idea to fight a "great cause" and a great idea to "make a huge profit", too. I've seen comments by hundreds of these braindead pro-GME loons but I haven't seen a single young person who actually had a brain and said something sensible about this phenomenon (like something resembling the text above; maybe these intelligent young people exist and are just intimidated into silence). Mankind is completely doomed when there is a 99.99% consensus in a whole cohort about something that is so obviously wrong and suicidal.

Shortsellers not only make profit in many cases. They are extremely important for the health of the financial system especially because they deflate similar cult-like bubbles. The GME stock is another great example of a security that a fanatical cult wants to make arbitrarily and insanely overpriced by making it artificially scarce. But shortsellers are great to stop or prevent this cult-like growth of the price because they provide the market with a supply (of the GME stocks, in this case) even if the long holders conspire not to do so! They – the counterparts of Mr Adam – agree to become a party in the contract with Mr Long and give Mr Long everything (of the financial character, especially the possible capital gains and dividends) that he gets from holding the real stock. That's how the effective number of stocks (the supply) increases. Everytime a new stock is sold short by a shortseller, a new stock is effectively "printed" and becomes available for those who want to possess it.

So what's happening is that a herd of millions of braindead sheep persuaded itself that it can change the reality and that the $10 banknote may be "made" worth at least $300. So they are selling $10 banknotes for $325 to each other. However, many of them are also buying pretty much identical $10 banknotes that the shortsellers are printing for them. The supply of $10 banknotes is going up. Of course they will eventually see that the $10 banknote is no longer scarce and it's just stupid not to sell it for $300 or $200 or $100 or $50. When the GME stock is no longer scarce, the scarcity argument will disappear and people will be forced to look at the dividends they get per stock and those will still be comparable to $0.38 a year per stock. So it's insane not to sell such a worthless stock for $50 or even more while you can.

The "overwhelmingly dominant" stupidity is one thing that scares me because the future of capitalism and the future of mankind looks bleak. Another scenario that scares me is that these loons – who should lose everything according to the kindergarten-level economics – will be bailed out by the government or someone. The poverty and starvation of these imbeciles will be declared politically incorrect by some far left apparatchiks and they will actually get those tens or hundreds of billions of the taxpayer money for the worthless stock they bought because, you know, they are holy anti-capitalist warriors who must be praised and celebrated. While the shortsellers may be deliberately hurt by a government intervention because those are evil capitalists (and making a self-evidently correct bet about the price is racist). If something like that happens, the path towards the cataclysmic collapse of the civilization will be accelerated further. So please, let these staggering imbeciles (who haven't learned that you shouldn't throw thousands or millions or billions of dollars into the toilet) starve!

Thank you very much.

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