Short-Squeezing in the Cave: An Epistemological Meditation

Every now and then I get inspired to do a post that is, how shall I put this, "out there." Way out there. It's all part of the magical charm of The Music Salon that sometimes we not only go off the rails a bit, we actually forge our own rails.

I was reading a Wall Street Journal story about the recent short-squeeze frenzy on Wall Street where a group of small retail investors actually shook the hedge fund world to its foundations leading the most unlikely pair, far-left Representative Alexandria Ocasio-Cortez AND far-right Senator Ted Cruz to make similar supportive tweets for the little guys. What is this, Alice in Wonderland? Not only that, but the WSJ titled its story GameStop, Bitcoin and QAnon: How the Wisdom of Crowds Became the Anarchy of the Mob which is way too prolix for the sober Journal.

In this case, their method was buying shares and options of GameStop in order to squeeze short sellers who were betting the stock would drop. The result was a buying frenzy that lofted the stock’s value into the stratosphere, well beyond any price at which it reflected a plausible future for the fundamentals of GameStop’s business.

Let me try and explain that a bit. You can make money in various ways in the stock market. Leaving aside the complicated situation with options, you can either buy a stock with good prospects, watch it go up, and then sell it at a higher price, or you can sell a stock (that you have borrowed from a brokerage) that you think has poor prospects (like GameStop), watch it go down and "cover your short" by buying shares at the lower price so as to return them to your brokerage. In both cases you pocket the difference. Using call or put options is a way of leveraging your profit--or loss, of course.

Now the situation with GameStop and a few other small companies or companies on the rocks like AMC, the cinema chain, is that some hedge funds had shorted the stocks so thoroughly that the stocks were as much as 140% short! This means that there were more shares sold short than actually existed. There really ought to be a regulation against this. But the consequence was that the hedge funds that were short the stock were uniquely vulnerable because if the stock started climbing steeply, they would have to cover their short at a higher price, i.e. lose money. You can only borrow shares to short temporarily (I'm ignoring margin rules here, which vary). Somebody noticed and shared it with a whole bunch of small investors over the internet who started furiously buying the stock. It doesn't take much to send a stock like GameStop soaring: today it is up 400% at this writing.

On a personal note, I once saw a stock that really was an absolute no-brainer: during the carnage of the Internet Bubble in 2000 shares in Salon, the media company, actually dropped to as low as they could go: one penny a share. I looked at this and thought, geez, buy those shares and if it goes to two cents tomorrow, you have a 100% profit! So I thought about buying a few hundred thousand shares. Alas, way back then, buying large quantities of shares involved very high trading costs, so I gave up the idea. But now, Robinhood and even big guys like Charles Schwab have NO TRADING FEES. And this definitely contributes to the frenzy.

I left a comment on the above story:

I have this strange mélange of images: a lonely hermit, solitary in his cell trading GameStop shares in his Robinhood account. It is like Cistercians of the Strict Observance all of a sudden had fiber optic connections. What a weird situation epistemologically. The Internet is reality while the ordinary physical world is almost irrelevant. Reminds me of the short story from 1909 by E. M. Forster: "The Machine Stops."

It also reminds me of the Plato's Allegory of the Cave where people cannot see the world as such, but only shadows on the wall of their cave. It is an image that seems ever more relevant today. The Internet in all its glory is still just digital wisps, like shadows on the wall of a cave. We only glimpse reality at a distance. The only reality that we are really sure of is that of our immediate surroundings. And these days for most people, those immediate surroundings are our own homes that we occasionally venture out of. So we spend all of our time in our own little caves, looking at shadows on the wall over our iPads, laptops or computer screens.

It is as if we are inside a giant machine that is feeding information to us. What if, one day, The Machine Stops?

And now for our musical connection. The link above is to the Wikipedia article on the prophetic short story by E. M. Forster written in 1909. About the same time, Schoenberg was undergoing a crisis in his life and out of it came one of the first atonal compositions, his String Quartet No. 2, here performed by Ann Moss and the Hausmann Quartet:

UPDATE: I should perhaps mention what is so risky about shorting stocks. I have done it myself in the past, but only on rare occasions. If you buy a stock in the ordinary way, which is known as being "long" a stock, the most you can lose is the value of the stock. If you buy 100 shares of a $5 stock, the most you can lose is $500 if it goes to zero. BUT, it is different with a short position. Say you short a hundred shares of a $5 stock and a bunch of crazy guys on the internet bid that stock up to, oh, $200 a share? If you have to cover your short, i.e. buy shares to return them to your broker, then you are going to be out, not $500 but 195 X 100 or $19,500. Theoretically, there is no limit to how much you can lose on a short! Which is why some big hedge funds just lost billions of dollars.