This article was updated on July 29, 2021, to remove some inflammatory language.
The meme that started it all, you can’t avoid outlandish arguments supporting the continued bullish case for GameStop (NYSE:GME). Among them, the one concept that continues to pop up is the idea that fraudulent action is artificially suppressing GME stock, specifically naked short selling.
Let’s back up for a second. When you short a stock, you are essentially attempting to make a profit from its sale at a higher price in the hopes that it drops lower. Should it do so, you then buy it back because you are contractually obligated to return the borrowed shares. The difference you pocket.
But what’s naked short selling? As John Olagues explained on Investopedia, “Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist.”
On paper, this shouldn’t happen. However, due to “various loopholes in the rules, and discrepancies between paper and electronic trading systems, naked shorting continues to happen.” Hence, the supposed opportunity in GME stock.
Basically, the idea is that the charade can only go for so long. Indeed, this was the original idea before the naked short selling argument gained serious momentum on social media forums. While shorting shares can be incredibly lucrative, it also exposes bearish traders to unlimited liability. That’s because while the downside limit for an equity unit is $0, no such countering argument exists for upside limits.
But when you add in the concept of naked short selling, the situation is even more bullish for GME stock. If the accusation is true — that is, there are more shares shorted than actually exist — the upside for the video game retailer would be unfathomably intense.
However, Olagues warns that speculators of any supposed naked-short play should be careful. Although “naked short selling is often given a bad reputation in the media because it is frequently abused,” Olagues writes, “it is not as nefarious as its critics suggest.”
Is GME Stock Riding a False Narrative?
On June 7, Dennis Dick, co-hosting an episode of Benzinga PreMarket Prep, stated that meme trades such as GME stock are banking on “a completely false social media narrative.” Dick argued that the “shorts might get squeezed, but there really isn’t a lot of naked short selling in practice.”
Further, he stated that meme traders are “misinformed” about what a short interest exceeding 100% actually means. Adding to this argument is an explanation by Bill Harts, former CEO of Modern Markets Initiative. According to Harts, a phenomenon called rehypothecation can drive short interest above 100%, sometimes well above it.
When a short seller opens a 100-share short position, he or she must first borrow 100 shares of stock. Those shares are then sold to a buyer to open a 100-share short position. That buyer can then turn around and lend out the shares to another short seller, which can open up a second 100-share short position on the same 100 shares of stock.
Because brokers aren’t required by law to tell buyers their shares were borrowed by the seller, Harts said that chain of rehypothecation can continue indefinitely and has sometimes resulted in certain ETFs temporarily having short interest of more than 1,000%.
Now, this isn’t to suggest that contrarian bulls of GME stock are necessarily wrong in their thinking. But the extreme optimism that we earlier saw in GameStop shares doesn’t necessarily mean that going long heavily shorted equity units is a surefire way of generating profits. In fact, the opposite can happen.
From the time that Dick made his warning until the time of writing (July 26), GME stock dropped over 34%. Needless to say, that’s not garden-variety volatility.
GameStop Can Rise But You Should Be Careful
Still, I think we need to give credit where it’s due. Although the euphoria around GME stock sometimes seems linked to worrisome trends, GameStop has been much more than a flash in the pan. It’s held up well relatively speaking. And as the recent cryptocurrency rally demonstrated, the longer you can hold above a baseline, the better odds you have.
Bottom line, I’m not going to write off GME stock completely but I’m not eager to add to my position. Personally, I’m playing with house money so I’m sticking around to see where GameStop will go. But if I were a prospective speculator, I’d probably look somewhere else.
On the date of publication, Josh Enomoto held a LONG position in GME. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
A former senior business analyst for Sony Electronics, Josh Enomoto has helped broker major contracts with Fortune Global 500 companies. Over the past several years, he has delivered unique, critical insights for the investment markets, as well as various other industries including legal, construction management, and healthcare.
