Reddit has achieved global finance infamy as the subreddit (forum) r/wallstreetbets has called out some over-shorted stocks.

Here’s why that’s the best thing ever.

What is short selling / shorting?

Short selling/ shorting a stock is buying something called a contract for difference (CFD).

I don’t dabble in CFDs. They’re the exact opposite of value investing.

When you “short” a stock, you borrow shares at the current price, with a bet that it will be cheaper soon. You promise to return the shares to their owner at an agreed date. You then sell the shares straight away, buy them at the lower price later, hand back the new shares and pocket the difference.

Contract For Difference… makes sense?

A lot of the time these are leveraged, i.e. people borrow money to do it. This multiplies whatever the difference is.

The risk of CFDs is that the share price goes the other way. If you’re short selling / shorting and the price increases, you now have to buy at the new higher price to meet your contract with the owner.

When you hear of people losing everything on the stock market or being in debt from it, CFDs are usually the reason.

What Reddit did

The subreddit r/wallstreetbets is a strange forum, where people talk about unorthodox and often foolish stock market speculation.

It’s entertaining, but it’s definitely not a place to get your financial advice.

The community basically decided to target two companies – New York Stock Exchange ticker symbols GME and AMC, that had a high level of shorting.

Members of the forum then bought the shares, until the share price was raised to new heights.

This is still in progress, but as long as the share price is higher than it was when most of the short selling CFDs were entered into by investment firms shorting the stock, those firms will lose their short positions and owe a ton of money.

Oh dear.

The firms (it’s mainly firms and US hedge funds) who are short will have to buy back shares to meet their contract… from wherever they can.

If there isn’t enough “liquid” in the markets, bad news for those firms. It also means that if the (new) individual buyers sell their shares later, they’re going to get the higher price as the institutional investors scramble to buy whatever is available.

Why this is the best thing ever

Reason 1: it discourages reckless speculation

This episode should show that even highly sophisticated investment firms can get burned with CFDs.

I don’t like CFDs, no value is actually created or company invested in, just paper gains and paper losses.

A lot of people trust in financial institutions (banks with an investment arm, for example) who take these risks. Reminding them not to repeat the 2008 financial crash and burn everyone’s money on high-risk bets is a good thing for the masses who rely on cash savings at the bank.

Reason 2: other shares should drop in price

If your company is an investment bank and you owe money, where is that money going to come from?

Initially, it’s profits. After that, though, you’re going to need to sell some assets. Shares. Decent, good value shares, as well as whatever speculative buys you’ve made.

In the short term, this might upset a few investors who hold such shares. However, it also means that serious investors can continue buying such quality shares at a value price. That’s good for little people like me, who can only invest little and often!

When the big institutional investors who still have cash notice this, they’re probably going to buy in too. The blip in a decent company’s price will probably be temporary.

Reason 3: it should discourage artificial price suppression

Shorting starts with a sale. That’s why it’s also called short selling. In the stock markets, selling reduces a share’s price.

You can see from that one paragraph how you could stack up short selling CFDs to make a self-fulfilling prophecy! Your first short CFD might become profitable because you took out the second. Meanwhile, genuine investors are wondering why their share portfolio is stagnating.

This might not be such a big deal for shares in companies, as the company could always choose to pay a dividend. You don’t need a high capital value if the price suppression means your little dividend is 8% that year! If anything, you’d be glad about it and buy more!

Where it sucks is when you look at commodities. For example, silver. Now, I don’t have any genuine insight here, but JP Morgan has been publicly spanked for manipulating precious metals prices, so neutering one of the tools for doing that seems like a good thing.

Why this doesn’t affect my FIRE plan

My FIRE strategy involved stock market investing, so you might think I’d be worried.

Wrong!

I only invest in either indices (through passive funds) or in companies based on a genuine value proposition. Short selling, CFDs, super speculative plays aren’t in my strategy for the stock market. I also have to dollar cost average my purchases out of necessity, so temporary blips aren’t a big thing for me.

To paraphrase from the Intelligent Investor by Benjamin Graham: stock markets go up, I don’t care! Stock markets go down, I still don’t care!

I’m still continuing with my FIRE campaign plan for 2021.