By now, anyone interested in investing is somewhat aware of the astronomical ascent, descent, ascent, descent and ascent again last week in the value of a small, rather obscure company that markets electronic games, Gamestop. Of course, the company stock is highly visible these days as anyone involved in any aspect of investing is well aware of Gamestop’s explosive valuation.

Moneywise first heard of this electronic video-marketing company probably 12 years ago when visiting a grandson. Hoping to buy him something that he desperately wanted for his birthday, off we went to one Gamestop store, situated in a strip mall near-by to a drop-in pizza parlour, and various other small businesses: repair shops, dry-cleaner, salon, etc.

Our grandson was, like most boys of that age, completely obsessed with electronic games - and would agonise over the many choices. He loved Gamestop because once his first choice was played ad infinitum and now too boring, and of course, the newest game was out, he could sell his now second-hand game back to Gamestop, receiving a credit against purchasing a new game.

The choices, in his mind, were so overwhelming that during that one shopping trip, we had to return a “first” choice twice in ten-minute sequences after leaving the store, in order to pick another “game that was better,” in his mind, at least.

All in all, my first impression of Gamestop then was as a second-third rate small company competing against the giant video-games distributors. What did I know! I was just shopping with the grandson.

That was the allure of Gamestop for a ten-year old!

Fast forward since that grandson’s birthday.

What was the phenomenal allure of investing in this tiny company for adults, bored, unemployed young men, according to some media opinion commentary? Certainly, not all participants met that label.

Was it just the thrill of the game, the chance to beat the established system, the camaraderie of like-minded day traders rapport through social media platforms, the defiant attitude and envy towards the established investment elite, or just riding on the get-rich bandwagon?

Why did Gamestop buyers keep buying and shortsellers keep shorting?

There are no clear answers, except for the fact that this stock and its investor participants, both buyers and shorters, based upon volume of trading, speed, interactivity among social media investors, and sheer dollars spent (and lost) precipitated an almost unprecedented capital market disruption – in a matter of days.

The monumental wave of buying (by the so-called Robinhood individual investors and Reddit crowd) overtook each layering of short strategies against the stock, thereby continually increasing the stock valuation that financially punished short-sellers. Finance media, in the aftermath of these astonishing valuation surges, reported an estimated $20 billion of losses in short-selling strategies.

How does this happen?

Short-selling, long-short strategies, doubling down, using margin leverage and options, going naked.

Let’s take a brief, basic look at how short-selling works, and why investors use the originally termed selling short as a value-protective strategy.

The personal investor. When a person, you, decides to invest personally, your first step is to open a brokerage trading account – that is used to accept your cash, to buy, hold, and sell securities as authorised by you.

Second. You, the individual also has the option to include a margin account with the general brokerage account opening. Why? Margin accounts are just that - using the leverage value of your existing stocks/securities to ante up your profits, but also can expose you to greater losses.

A margin account allows you, the investor, to borrow against the value of your stock in your account at the time – to buy more securities. To double up, as it were.

Caution: margin accounts are not generally recommended for beginning do-it-yourself investors. Reasons will be discussed in future articles.

Third. Your brokerage account opening is a contract with the broker – usually a pretty detailed document, and here is an often unrealised component of this contract – generically speaking.

Your broker/brokerage firm has the right to sell your stock for someone else, charge a commission to do so, and assess interest on that person – who may happen to be a short-seller investor. Your broker is liable also and must replace that stock; either by it being returned by the short-seller or taking the stock from the brokerage firm’s inventory.

Note: even though it is your stock you do not benefit from the commission or interest charged to the short-seller.

The short-seller investor. Now, having given you that bit of interesting, some say totally confusing information, here is how short-selling works. We’ll use a hypothetical company, BlueStar, a publicly-listed company whose stock appears to be struggling to hold its current value, possibly because analysts feel their future sales may decline. Remember this is hypothetical!

That analysis then triggers our short-seller’s inclination to actualise a profit on a declining stock value.

The short-seller does NOT own this stock, but implements a short sale through his/her margin account, by contacting his broker to action a significant short sale of BlueStar stock at the current value of $40 a share for 100 shares. $4,000 less commission etc is deposited in the short-seller’s account.

The short-seller also has a certain time frame to replace this stock, no matter his/her cost to buy the stock back. Remember he/she sold it!

Going naked. This short-seller does not own 100 shares of BlueStar stock. This means he/she is totally exposed to any rise in BlueStar stock value.

There are two scenarios.

One: the short-selling game profits when the stock value drops.

Bluestar stock value falls $15 per share. Short-seller scoops up 100 shares at $25, then returns the bought shares to his broker. Presto, Profit of $1,500 – boy, was that easy.

Two: the short-seller is caught naked when the stock value rises above the sale price of $40.

Social media investors, and investors of all types believe BlueStar has intrinsic value. They bid the stock up in a matter of hours to $65 per share.

You know the rest. Short-seller must cover and is forced to pay $65 per share in buying it back.

You know the rest! Big Loss.

More on this fascinating topic in coming months

• Martha Harris Myron, CPA JSM, a native Bermudian, is the author of Bermuda Islander Financial Planning Primers https://www.royalgazette.com/bermuda-islander/, consultant to the Olderhood Group Bermuda, and financial columnist to The Royal Gazette, Bermuda. All Proceeds from these articles are donated to the Salvation Army, Bermuda. Contact: martha@pondstraddler.com