There’s a lot going on in the stock market this week and both and Reddit in general are inundated with questions about it. This is an opportunity to ask for explanations for concepts related to the stock market. All other questions related to the stock market will be removed and users directed here.
How does buying and selling stocks work?
What is short selling?
What is a short squeeze?
What is stock manipulation?
[What is a hedge fund?](https://www.reddit.com/r/explainlikeimfive/comments/l6ptb7/eli5_what_is_a_hedgefund/)
What other questions about the stock market do you have?
In this thread, top-level comments (direct replies to this topic) are allowed to be questions related to these topics as well as explanations. Remember to follow all other rules, and discussions unrelated to these topics will be removed.
**Please refrain as much as possible from speculating on recent and current events.** By all means, talk about what has happened, but this is not the place to talk about what will happen next, speculate about whether stocks will rise or fall, whether someone broke any particular law, and what the legal ramifications will be. Explanations should be restricted to an objective look at the mechanics behind the stock market.
EDIT: It should go without saying (but we’ll say it anyway) that any trading you do in stocks is at your own risk. **is not the appropriate place to ask for or provide advice on stock buy, selling, or trading.**
In: Economics
Here’s something that was never 100% clear to me- what’s the actual process that takes place when a share is purchased or sold that makes the price go up/down? For example, John owns a single share of Random Company, currently being traded at 100 dollars a share. John decides to cash in and sell his share. He would then approach the stock exchange where the trading takes place (well, his broker in real life, but whatever), and state that he owns a single share of Random Company and would like to sell it for $100.
The end result of that is John gets $100, and the price ticks ever so slightly down.
My question is concerned with why does it go down, and who/what decides that. The economic mechanism of supply/demand is clear to me, but since this isn’t really a marketplace where bartering can take place, it’s not like potential sellers would see that John has just sold his share and would therefore adjust their offered price- it all happens independently from the traders.
So what happens there? Does the stock exchange’s algorithm adjust the price because more shares are now available for purchase? Something else?
Here’s my explanation that I told to a friend.
There’s a way called “shorting” to profit off of dying companies.
(Consider + as profit and – as loss)
Short Procedure:
1. Borrow a stock that is expected to drop. ( – small borrow fee)
2. Sell it for current price. ( +Original stock price)
3. Wait for it to drop.
4. Buy it back much cheaper. ( -dropped price)
5. Then return the stock to the owner.
Total Profit = original stock price – dropped price – borrow fee
Risk: If the company’s stock rises instead of falling, you will sustain losses.
Loss = Inflated Price + Borrow Fee – Original Price.
This is hence considered a risky practice.
Back to the story,
In lockdown GameStop was suffering major losses and it’s stocks were dropping, so many big businesses and a large number of people decided to short it.
If you look back at the short procedure, there’s a long waiting period.
The status at this waiting period is that you owe the original owner one stock. (The stock you borrowed and then sold and are now waiting for it’s price to drop)
Now suppose another person wants to short GameStop.
This person may borrow the stock that you just sold, from the person that you just sold it to. (In other words, this person will borrow one stock from the person who brought one stock from you).
Notice the problem here.
There only one stock, but there are two people who owe someone that stock.
In other words, two people think they own a stock but there’s only one stock available to own.
Soon, there will be more people who owe a stock to someone, than the total stocks that are there.
This happened to GameStop, where 140% of it’s stocks were sold as short. But there’s not enough stocks for this many people to own.
Now imagine the stock price goes up instead of down, (say the company did something great), people will panic and try to buy back the stocks they sold so as to not sustain losses. (Why do they buy back? Because they need to return the stock to the owner.)
But there are not enough stocks to go around. This will increase the demand of stocks and supply will be short, further increasing it’s price, this cycle will continue and the stock price will keep on increasing because of the high demand and low supply. Note that this didn’t happen yet.
(Btw why are there not enough stocks? Imagine the story earlier, after noticing the rise in price, you decide to buy back the stock, but instead of asking the person you sold to, you ask the person currently owning the stock, now you return the stock to the original owner and you’re relieved, but what about the person you sold the stock to the first time? There was only one stock which has returned to it’s owner, there’s still one guy who owes someone a stock and one guy who thinks he owns one stock.)
Now comes reddit,
Note: If many people buy a particular stock, it’s price will increase because of the increased demand and shortened supply.
The small investors on r/wallstreetbets decided to take advantage by buying GameStop’s stocks and increasing the stock price, this will start the chain I explained just now, where the people who have shorted will buy back to avoid losses, but due to the lack of stocks, it’s price will further increase, and more people will pull out of the short and the price will increase again, and so on.
Before lockdown, the stock price was $4 apiece. Recently it reached $147, and one day later $345. The price is skyrocketing.
The big investors and billionaires that decided to short and take advantage are losing money in billions, while the small investors are making loads of money.
But GameStop is not as valuable as it’s stock price, so this inflating bubble will burst, and the prices will crash.
When this happens, if you invest by looking at the rising prices, you will lose a lot of money, but you can profit if you short at the correct time.
Sigh.
GameStop explained –
Remember the toilet paper shortage we went through?
GameStop is the toilet paper.
Melvin Capital is the price gouger who borrowed a bunch of TP from Charmin (broker) at “future” normal post-pandemic prices ($1) and sold it to the public at current prices ($5).
Pandemic over, Melvin has to return TP to Charmin buuuuut Reddit decided Melvin bad and toilet paper good and bought all the TP forcing Melvin to buy it from them for new price of $50 or pay Charmin extra for collateral.
Melvin’s friends got mad that Reddit acted like Melvin and they closed Charmin’s doors so Reddit couldn’t buy anymore TP.
Now AOC and Trump Jr have joined forces and are having lunch discussing ways to punish Melvin’s friends so that Reddit can put all the toilet paper in a rocket ship.
How does buying and selling stocks work?
.
I own an orange factory. I want to raise money for building a new navel orange machine, so I issue orange stock. I make a special orange that you can buy for $1. I issue 1 million oranges, and raise $1 million. You now own an orange for every $1 you gave me.
That’s all you get. If you’re lucky, I might give you a fraction of how much I make with the new orange machine every year. But you buy the orange share because other people will want it later, when my company is big and successful, and you can try selling the orange share for more than the original dollar.
.
What is short selling?
.
You have 100 of my oranges. I come up to you Monday and say, “If you loan me those 100 oranges, I will give you $2 and your oranges back Friday. You agree, and I go off and sell your oranges for $1 each. I have $100 and owe you $2 and your oranges back. I hope your oranges will be cheaper Friday, and if they are only worth 50 cents, I buy 100 oranges and give you them and $2, and I am $48 richer.
.
What is a short squeeze?
.
Someone saw me make the deal on the oranges, and then immediately sell them. They know I have to have 100 oranges on Friday. So the go buy up all the oranges, and on Friday, when I try to buy oranges, they are standing there with a sign that says “oranges for sale $20.” Anyone who wants to sell oranges is selling them there. I have to buy from them for $20 an orange. Now I have lost $1900 dollars buying the oranges back, and still owe the $2.
.
What is stock manipulation?
.
When I buy the 100 oranges, I go around and talk about how bad oranges are. I tell my friends not to let anyone buy oranges so demand drops. I go on CNBC and talk about how I bit into a nasty orange and threw up. Now oranges are 25 cents. How wonderful… I can buy my 100 oranges for $25, and now my profits are $73!
Lets start with a baseline: there is a city, and in that city people are **trading apples**.
>How does buying and selling stocks work?
If you want to buy an apple, you can walk up to a shop (a middle man, a broker) and ask them to buy an apple. The shop owner then gets apples from the farm or from someone else and sells them to you at the price that is agreed upon. If you want to sell an apple, you can set a price or agree to a price that the shop owner wants to buy your apples at.
If more people want apples, the price goes up, as there is more demand and fewer apples. The sellers can ask more money.
If less people want apples, the price goes down because they might be stinky apples no one wants.
>What is short selling?
You have an apple. Its worth $10 in your city. I walk up to you, and I tell you, let me borrow your apple. I will pay 1$ to lend it for every week I have it. You agree.
As soon as I get it, I sell it for $10. I now have money and no apples. One week later, the price of apples goes down to $5. I buy an apple at $5 and give you your apple back. I’ve made $4 profit (since I paid $1 to borrow it). I have shorted apples. I have made money on the price of apples going down.
If the price went up instead, and I was wrong, I lose money when I have to buy the apple back to give back to you.
>What is a short squeeze?
If tons of people in my city are shorting apples, but the price actually goes up (I was wrong) they are in trouble! The price could technically keep rising and their risk is infinite.
Now if demand goes up, and people suddenly LOVE apples, those people that shorted get really really nervous. The higher it goes, the more it costs to buy back the apple (cover).
When the first person that shorts breaks, and buys back apples, the demand raises, and the prices goes even higher!
Now suddenly shorters are racing for who can buy back first, making the price explode like a bomb.
>What is stock manipulation?
People doing funky things with apples to wrongly give the illusion the apples are worth less. For example, they can lend out apples that they just borrowed from someone else, or say that there is a worm infestation when really there is not. Or they can close apple shops altogether, which would be really bad and illegal.
>What is a hedge fund?
Its like an apple king in your city, they have a lot of apples and/or move a lot of apples, making a lot of money in doing so. They have a lot of power to influence the price of apples to their benefit.
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>How does buying and selling stocks work?
Buying and selling stocks is quite simple. A stock in a company has a certain price. The more people who buy that stock, the value of the stock goes up. Demand is increased, so price goes up. Conversely, if a lot of people sell a certain stock, the price goes down.
>What is short selling?
Short selling is what you can do if you think the value of a stock is going to decrease. Here’s how it works. Let’s say you think stock XYZ is going to decrease in price within one month. You, through your broker, can short sell it. When you short sell, you “borrow” a certain number of stocks from someone who holds them. Let’s say you borrow 100 shares of XYZ at $100 per share with a total value of $10,000. Once you borrow them, you sell them at $100 per share for $10,000. If a month later the price of XYZ goes down, let’s say to $50 per share, all you need to do is buy 100 shares of XYZ at $50 per share for $5000 and give it back to the person you borrowed from (minus a small principle). You get to keep the difference between the price you sold it for ($10,000) and the price you bought it for ($5000), which is $5000.
However, if the price of the stock does not decrease, you are still required to return the same number of shares you borrowed. Let’s say XYZ doesn’t decrease in value but jumps from $100 per share to $150 per share. By the end of the month, you are required to buy 100 XYZ shares for $15,000 in order to return them (minus the principle you owe). You have now lost $5000 in your short sale because the stock increased in value.
>What is a short squeeze?
A short squeeze is when the price of a stock is driven up (by purchasing the stock) in order to cause people who short sold the stock to lose money. The most popular short squeeze at this moment is GameStop or GME. A bunch of hedge fund managers short sold GME, which was trading at ~$20 per share at the beginning of the year, anticipating that it would drop in value. People at r/WallStreetBets saw this and decided to coordinate to buy GME and drive the price up. Currently, GME is trading for $350 per share. That means people who shorted GME at $20 per share, must now pay 17.5x what they borrowed in order to return the shares to whomever they borrowed them from.
>What is stock manipulation?
By definition, “Market manipulation is the act of artificially inflating or deflating the price of a security or otherwise influencing the behavior of the market for personal gain.” You could argue that what r/WSB has done is market manipulation, as they have driven up the price of a stock (GME) that has nothing to do with the value of the company or any natural market forces. Conversely, you could also argue that what Robin Hood did when they banned users from purchasing GME was market manipulation, as they took actions that affected the price of a stock regardless of what the market was indicating.
>What is a hedge fund
A [hedge fund](https://www.investopedia.com/articles/investing/102113/what-are-hedge-funds.asp) is “a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.” It’s basically a bunch of investors using money that is not theirs in order to make money in the stock market.” It’s basically a bunch of people getting together, pooling their money and telling a fund manager, “You can trade with this money we’ve pooled together to either go long if you think the market will rise or short if you think the market will go down.”
For people that don’t understand **shorting**; here is my best explanation at it (this is heavily inspired by a YouTube video)…
**Shorting is when you think a company is going to do badly so you borrow that company stock from a broker and promise to pay them back later.**
Here is a Non-Stock Example:
Imagine that you thought **apples were going to go down in value** and they currently cost **$1.**
You go to a shop keeper and ask if you can borrow an apple which you will give back later.
You borrow the apple from him and sell it someone for $1 and then wait for the price to change. If the price goes down to 50 cents then you can buy 2 apples for a dollar. You go back to the shopkeeper and give him back the apple.
**He has an apple back and you have an extra 50 cents.**
**In stock market terms you have shorted them apples**. Now replace the apples with stocks and you hopefully get the idea.
2 other things worth mentioning about short positions f**irst you have to pay an interest rate** **on your short positions** because you’re borrowing something.
Secondly, **short positions can be greater than 100% of stock.**
**Let’s get to GME**
GME is a brick and mortar video game company, after Covid hit Gamestop **unsurprisingly** has a couple of bad months and revenue falls. GME falls to about $4 per share.
Largely because of this many **big international investors essentially thought Gamestop was going to go bust and therefore shorted GME.**
Hoping to see it collapse, they didn’t see that there was some good news coming Gamestop’s way.
Firstly in **Mid August our saviour Ryan Cohen started buying GME shares.** By December Cohens company had bought about 9 million share (13% GME).
Then in January Cohen and some other CEOs were appointed to Gamestop’s board.
This gave Gamestop a huge advantage as **now they’ve got a billionaire investor who’s experienced with running ecommerce companies** which is exactly the business model Gamestop needs to shift to.
Secondly in **November PS5 and Xbox series X was released starting a new console cycle** which is good news for Gamestop.
Thirdly Gamestop **signed a deal with Microsoft which gave them a share of all of Xbox’s digital revenues**
So, what happened to the stock?
Firstly, the institutions that were shorting GME bought more short positions to try to supress the stock price.
This chart shows that for example on January 11th **there are massive 4 million short positions** taken despite the fact that this was the day Cohens board appointments were announced.
📷
In total 71 million short positions were taken even though Gamestop only had a float of 69.75 million shares. Remember you can have more short positions that actual shares.
This gets crazier because about 20% of Gamestop shares is held by insiders like Cohen. Insiders can’t sell easily because of regulations.
📷
There is the same amount again owned by big institutions who don’t normally trade either.
📷
**So that leaves between 20 to 30 million actively traded stocks and 71 million short positions who all need to buy stock**
That is a lot of demand and not much supply. Wallstreet Bets realized this and determined that if they bought the stock and **held** they could force the price up which triggers a **short squeeze.**
Where people with short positions desperately buy into a stock and try to cover before the price gets too high. These people are losing money but covering now prevents them from bigger losses.
**However because there isn’t enough stocks to go around the price of each stock jumps spectacularly**.
Remember it costs money to shorter position forever because of interest **so they want to act fast** which is exactly what happened to Volkswagen in 2008. Where it breifly became the most expensive stock in history. **Which is exactly what is happening with GME right now!**
📷
Ulitmatly Redditors made big money and **if you hold for longer you will make more.**
The 2 big short sellers who lost big money is **Melvin Capital and Citeron Resarch.**
**You can tell that they are panicking because 2 days ago Melvin Capital had to be bailed out by 2 big insitutions which isnt good for them.**
**There is a lot of short postions to be covered if you hold for longer the price for each stock will increase.**
Secondly if you’ve seen anything about this in the news it’s often spun as mental reddit investors ruin the market **there’s three things worth saying here**:
Firstly, wall street bets doesn’t actually **hold much sway over the market itself as WSB is an internet forum not an institution**.
Secondly, it’s not as if the market was rational **beforehand it’s just that only hedge funds used to be able to manipulate** it and this wasn’t even clear manipulation obviously some of GME’s rise is a function of speculation but there’s a good argument that it was undervalued and over shorted to begin with.
Thirdly it’s fundamentally a good thing that people are able to get into the stock market and make **money off GME as it might make things more volatile and harder for hedge funds.**
But fuck Wall Street.
tl;dr: Melvin Capital and other big short shellers were caught with their dick in the cookie jar when they overshorted GME making GME shares go to the fucking moon. If you hold GME you could be able to go to fucking Alpha Centuri and bankrupt big short shellers
Ok, i’ll try my best to explain. Buckle up. this is going to be long. There is no ELI5 Version.
Buying and selling stock is done through a stock exchange via a broker (Interactive brokers, E-trade, robinhood, etc…) If I wanted to buy let say 10 shares of apple. I would place a bid at let’s say $100 per share so I would need $1000 Capital. You put this request in and once it’s accepted you now own 10 shares of apple. 2 years down the road, I want to sell my apple stock which is now worth 200/share. I will simply place the bid at $200 for my $10 shares and gain a profit of $1000 (2000-1000 initial investment).
SHORTING: Now brokers usually have settings that enable users to OPT -IN (Default Setting)/ OPT OUT for lending your shares to others. So using my example of apple shares. If I OPTED IN – a hedge funds, an institution can “Borrow” my 10 shares to sell to other people and pay back lets say in a week or so.
**NOTE: THEY DON’T PHYSICALLY BORROW THE STOCK, BUT IT IS DONE THROUGH THE BACKDOOR- MOSTLY NAKED SHORTING AND BROKER MARKS IT ON A PIECE OF PAPER THAT JOHN SHORTED 10 APPLE STOCKS. TYPICALLY YOU SHORT ABOUT 20% OF A STOCK AND THAT IS A LOT AS WELL, ANYTHING HIGHER WILL GET YOU IN DEEP TROUBLE IF THE PRICE MOVES AGAINST YOU. YOU NEED A LOT OF MONEY IN ORDER TO DO THIS AS IT IS VERY RISKY. GAMESTOP WAS SHORTED 140% FLOAT, which means they shorted more than the available numbers of shares on the market (100%). THEY CAN’T BUY BACK ALL THE SHARES AND HAVE CORNERED THEMSELVES.**
Why would someone do this you may ask? This is so they can sell the shares of apple continuously to drive the price of the stock down and cause panic and selling event, then come in later to scoop up the shares at dirt cheap prices and pay off the borrowed shares.
Continuing our example, lets say 1 week later, Apple is now trading at $50/share. Well the Hedge fund now can return my 10 shares, but it only cost them $500 instead of $1000. So they made a profit of $500. They can do this as many times as they want and will make money AS LONG AS THE PRICE GOES DOWN. **what about if the price goes up**? **This is where RISK MANAGEMENT comes into play. Theoretically, their loss is INFINITE, which is what we are witnessing as GameStop stock price keeps going up and they are adamant in lowering it.**
**Now lets switch gears and dive into GameStop. As mentioned previously, it was shorted 140%. The people on Wallstreetbets found this out and recommended that hey, take a look at this, this isn’t right, the company isn’t doing bad. The recent sales of PS5 consoles went great, I think GameStop has potential and is undervalued. I’m not telling you to buy the stock, but hey this is where it could go. THIS CAUGHT ON FIRE and everyone bought GameStop shares only because “It’s a good company, and we like this stock”**
This is where it gets interesting. Now our old friend JOHN who shorted the apple stock, also shorted 140% of GameStop. How do you close your short position? You have to buy back the stock. Well the stock went up. So John has to buy at the higher price in order to close his position, but remember he can’t close all of his position because there is not enough available shares for him to buy back. Also his loss is infinite because the price can theoretically go to infinity, If John had a million dollar short position, he’s not on the hook for more than a million, he’s on the hook infinite amount technically. **THIS IS THE GREATEST TRANSFER OF WEALTH WE ARE WITNESSING.**
SHORT SQUEEZE:
Our Friend JOHN can choose to close his position only if the shareholder of GameStop agrees to sell to JOHN. If someone agrees to sell to JOHN at $100, then great he can close some of his positions, but what if they refuse? John must go to the next seller at $200 and buy the stock at $200/share. What if they refused? Next person at $300 and so on and so forth until he can close all of his position. This is where the price is being squeezed higher and higher by buyers refusing to sell their stock of gamestop.
I could type more, but I’ll stop here.
THE RICH GOT CAUGHT WITH THEIR PANTS DOWN AND THEY ARE ON THE HOOK for BILLIONS OF DOLLARS TO THE AVERAGE JOE LIKE YOU AND ME.
Melvin is in 5th grade.
He goes to a school where kids sell different kinds of candy to each other on the playground.
Melvin is friends with an older, bigger kid named Essie-C. He makes sure that all the candy sales on the playground happen fairly. If a kid doesn’t pay for the right price for the candy, or if the kid selling the candy just takes the money, Essie-C beats them up. Teachers at the school let this all happen because the kids like candy, they are better behaved when they have it, and Essie-C is generally a pretty trustworthy kid who is feared by the bad kids.
A delicious new candy called Chee’umee has come out, but it’s only available in Japan. It’s the perfect candy in every way, EXCEPT that many of the batches spoil very easily. The candy is so good though, that people still buy it, even with the possibility that they might end up with spoiled batch. Normally the wrapper of the candy is bright metallic green, but when it spoils, it turns black.
Melvin is friends with Essie-C. One day, Melvin has an idea and pulls Essie-C aside.
Melvin: Hey Essie-C! Have you heard about this new Japanese candy called Chee’umee?
Essie-C: Nope.
Melvin: Well, it’s really good and I want to sell it to the kids on the playground, but I don’t have any with me. My dad is going on a business trip to Japan next month, and he can bring some back for me. Would it be cool if I sell the other kids IOUs? Then when I get the candy, They can exchange their IOUs for the candy!
Essie-C: OK
Melvin: Well, there’s one more thing. The Chee’umee might spoil before the kids get to exchange the IOUs for it. If that happens, is it okay if I keep the money they paid for the IOU? The kids I’m selling to will need to understand that we might get a spoiled batch and their IOUs won’t be worth anything.
Essie-C: Sure. But you’d still have to give them the spoiled candy, if they want it.
Melvin: No kid would want the spoiled candy!
Essie-C: Them’s the rules.
Melvin: Fine…
On the playground, Melvin follows this plan and sells 140 IOUs, which are little slips of paper to all the kids on the playground. He makes a lot of money that day.
Later that evening, Melvin talks to his dad, Sid Atell, at dinner. Melvin: Dad, when you go to Japan, do you think you could bring back some of that Chee’umee candy?
Sid: Sure, son! How much do you need?
Melvin: Well, I was hoping for… 140 pieces?
Sid: Goodness, son! That’s a lot! I don’t think I can bring that much back. I can bring back, oh about 20 pieces. Would that be okay?
Melvin: Sure I guess. Here’s the money for the 20 pieces.
Melvin figures he will just tell the 120 kids that their candy got spoiled on the trip back from Japan. But this is great for Melvin, because he only had to pay his dad for 20 pieces of Chee’umee!
A month later, his dad returns from his trip to Japan with 20 pieces of candy, and all but 5 turned black. Melvin takes all the candy to the playground and exchanges all 5 of the shiny green metallic candies for IOUs. The 5 kids who got the green candies are excited and the candy is as delicious as advertised. The other kids are quite annoyed that so much of the candy spoiled.
3 kids, Wally, Sam and Betty, are a little suspicious of Melvin, so they ask for their candies anyway. Melvin hands it over.
Wally, Sam and Betty open the candy and eat it. To their amazement, the candy is just as good! Better, even! The wrapper just turned black, but the candy itself is just fine! Wally, Sam and Betty tell all the kids on the playground to use their IOUs and get the candy even if it’s in a black wrapper.
Melvin is now in a tough spot. He goes to Essie-C for help, but Essie-C reminds him of the deal. All IOUs have to be exchanged, if the kid wants their black-wrapped candy.
As a last ditch effort, Melvin goes to the playground teacher, Mrs. Robin Hood to tell her of his predicament. All these kids have IOUs and they really want the candy, but he can’t give it to them.
Edit: Holy cow thanks everybody for the awards.
Cleaned up some grammar.
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