Stocks, Brokerages, and Short Squeezes: What Are They?
A major hole in our education system is financial literacy, particularly in the stock market. With the current ease and prevalence of investing options, it’s important now more than ever that we start teaching our youth financial terminology and concepts. My interest in the stock market started in high school, when I bought $100 worth of Marvel stock with two other friends. I would watch the price obsessively over my parents dial up modem and when it went up, I sold it for some short-term profit. If I had kept the stock though, it would’ve been worth a LOT more–an early lesson in investing.
What I’d like to go over in this article are basic terms and concepts that I’ve learned from my dad, self study, and managing my own investments. My dad would give me reading assignments as a young adult with one of the first books being Warren Buffet’s biography. I didn’t quite understand it at the time, but one take away was: to invest for the long term and invest in companies that offer strong value. How Buffett did this was buying stocks in businesses he believed in.
So what are stocks?
Stocks: a Share of Ownership
Stocks, also known as equities, are shares of a company. For example, let’s say Adam starts a bakery, Adam’s Baking Company (ABC), that sells Taiwanese baked goods. Customers love the pastries and the company does ok. Adam decides to raise money to expand his business. To do so, he offers shares of stock, which are slices of ownership in his company.
His business is valued at $100,000: please note that valuating a company is complex and takes in many factors such as how much money the business makes, future outlook, market demand, etc…and is worth further exploration but is beyond the scope of this article. Adam divides his company evenly into 10 shares, selling each share at $10,000 (1/10 of his company or 10%) to the public in an intitial public offering (IPO). Adam wants to keep a large percentage of ownership, so keeps 4 shares for himself and sells the rest. His brother, a big supporter, buys two shares of stock. Two of his friends and two investors buy a share each, making the ABC company ownership:
Adam: 4 shares, 40% owner
Brother: 2 shares, 20% owner
Friend 1: 1 share, 10% owner
Friend 2: 1 share, 10% owner
Investor 1: 1 share, 10% owner
Investor 2: 1 share, 10% owner
Adam uses the $60,000 he received from selling six shares to expand his bakery into the empty store next to his shop. Let’s say business goes well over the next two years and his company is now valued at $200,000. What that means is each share doubles in price: $200,000 divided by 10 shares equals $20,000 a share. Investor 1 wants to cash in and puts his share on the market, Investor 3 buys it. Investor 1 therefore makes back his principal investment of $10,000 and a profit of $10,000.
Adam’s brother still believes in the business but wants some money back to help pay for a house. He sells one of his shares at $20,000, thus making back his principal investment, and holds onto the other share with hopes that it increases in value. This is known as playing with the house’s money: even if the leftover share were to drop all the way to zero, he’d still be breaking even (no loss, no gain) since the stock at any value above zero would be considered profit for him. This is a common investing strategy.
I’ve oversimplified things, but this basically illustrates how stocks work. So when you buy shares of stock in a large company like Tesla or Nvidia (full disclosure: I own shares in both companies), you’re buying partial ownership in that company with hopes that the stocks will increase in value in order to sell at a later date for profit.
Brokerage: the Middleman
In the above example, how did Investor 1 and Adam’s brother sell their shares of ABC? Most individual investors use a brokerage, a company that connects buyers and sellers of stocks. If you want to start investing, you may find a brokerage at your bank, many of which have a brokerage part of their business such as JP Morgan Chase. Some brokerages also offer banking options like Charles Schwab checking account which comes with a brokerage account (not paid endorsements, though I do use both companies). Some brokerage companies you may have heard of: TD Ameritrade (purchased by Schwab recently), E-Trade, Webull, Robinhood. The last one, Robinhood, got a bad rap recently for restricting the buying and selling of Gamestop, AMC and other stocks during the short squeeze last month (a term we’ll cover below).
Brokerages offer online and mobile trading options for stocks which have opened up the world of stock trading to younger, amateur investors. Brokerages make money by charging fees for each transaction (buying and selling of stock), however, many brokerages like Fidelity, Schwab, TD Ameritrade have dropped their commission fees to zero. These brokerage firms can still make money through various devices like payment for order flow or by using the idle cash you hold in their accounts in investments.
When choosing a brokerage, it’s important to look into any fees they may charge, minimum account requirements, and the services that they offer. Also, and this is important, the ease of their user interface and their customer service.
Short Squeeze: to the Moon and Back to Earth
So this term has gained renowned notoriety for being the reason why Gamestop stock, which was at $20 a share mid-January 2021, to jump to astronomical prices of over $300 a share (that’s over 15x increase in value). How does something crazy like this happen? To understand this we have to understand what a short is.
When you buy and hold a stock, you’re betting a stock will increase in value over time. Now, if you want to bet that a stock will decrease in value over a specific duration of time, you can do a options/margin trade called short selling. Short selling is when you borrow stock from a brokerage, sell it at its current price, then if the stock goes down within a set period of time, you buy back at the lower price and return those shares to the brokerage. The profit you make is the difference between the initial sale and the lower buyback price. The problem with short selling is that the potential loss can be infinite: if a stock goes way up instead of down, like the case of Tesla last year which cost short sellers billions of dollars, you have to buy back at a higher price when you first borrowed the stock and you would have to pay the difference.
Prior to January 2021, companies like Gamestop (GME) and AMC were heavily shorted by hedge fund companies that felt confident that these companies would eventually fall in value. However, when the reddit forum Wall Street Bets pooled together to push GME stock to the moon, hedge funds shorting the stocks lost large amounts of money because of the stock price increase. To cover their losses, the hedge founds bought back shares of GME before the price jumped even higher, which further increases the price due to increase in demand. This is known as a short squeeze.
As we’ve seen now though, such jumps in prices are not sustainable and many times the stocks return to a more earthbound existence.
Note: I personally advise you not to short sell or do any type of margins or options trading unless you’re incredibly educated in these investment vehicles and/or a professional trader. Even then, I would be cautious. These types of investments are incredibly risky and can create a lot of anxiety. A poor 20-year old investor died due to the mental strain options trading caused and an inefficiency in the Robinhood app that he was using for trade.
Hopefully the concepts above give you some insight into the stock market system. Check out the websites I’ve linked and the many other resources online to help better increase your financial literacy. In this way, I hope it helps you towards financial independence.
