You don’t have to be a market addict to know about the GameStop affair—over the past few weeks a pirate army of mostly young retail investors has sent the company’s stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. price soaring and plunging, and may have made a hedge fund or two walk the plank. But how did they manage it? To answer that question, you need to understand shorts and short squeezes. We’ll explain.
In some ways, investing in the stock market is straightforward. Identify a company you believe will be more valuable in the future and buy its stock. If you’re right, when the day comes to sell the stock, it will have risen in price and you’ll make a profit. You buy now, intending to sell later.
But what happens if you come across a company you think will be less valuable in the future? If you’re right, buying the stock outright does you no good; you’d lose money. What you’d really like to do is sell now, while the price is high, and buy later, when it’s low. That might sound impossible, but this is Wall Street and Wall Street finds a way.
Betting that a stock will decline in price is called short selling. Here’s how it works: You pay a fee to borrow stock from a broker when shares are worth, let’s say, $100. Then you sell the borrowed shares on the market. Now you have $100 in your account—but you still owe that broker his or her shares. Eventually, you must buy shares back from the market to make the broker whole.
In a successful short, the price of the stock drops from $100 to, let’s say, $80. You buy the stock on the market and return it to the broker. You’ve made 20 bucks on the trade, less the fee you paid the broker.
What happens if you bet wrong, and the price goes up? You’re still obligated to return the shares to the broker. If your stock goes up to $125, when you buy shares and return them, you’d lose $25 on the trade.
The key difference between buying a stock and shorting a stock is the risk-reward potential. When you buy a stock, the worst you can do is lose the amount you invested. That’s not fun—but at least you know the worst-case scenario. And your upside potential is limitless. As long as the stock goes up in price before you sell, you’ll keep making money.
With a short, the equation is flipped. There’s a limit on how much you can profit: The best you can hope for is that the company’s stock goes to zero. In our example, you’d make $100 if the stock went to zero, but you can’t do any better than that. And there’s no limit to how much you can lose. When you’re short, the higher the price of the stock rises, the more you lose on the bet.
This dynamic is what creates a short squeeze. As a stock’s price goes up (and up), it becomes more painful for short sellers. At some point, they need to stop the pain—cut their losses—and buy the stock. Buying the stock pushes its price higher, putting more pressure on other people who are short. If everyone who’s short rushes to the exit at the same time, well, you get the type of action we’ve seen with GameStop and a few others recently.
It may seem strange that a loose confederation of retail investors would have the power to sway markets. One contributing factor is that today’s online brokers and the retail investors they serve have been heavily promoting the use of options. Another factor is social media posts by CEOs and prominent internet influencers who are pouring fuel on the fire.
Regardless of the underlying cause, we think the gains in these stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. will prove fleeting. The price spikes of GameStop and the rest are clearly untethered from the underlying value of these companies and devoid of real research into fundamentals or critical thinking. A social media crowd targeting a stock that’s been heavily shorted can send a stock into the stratosphere, but someone is going to be left holding the bag when the fuel runs out.
Vanguard to Launch First Active BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates.ETFA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index.
Vanguard filed with the SEC to launch its first actively managed bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. ETF in January. The fund, Ultra-Short Bond ETF, will begin trading in the spring.
Though technically a separate entity, the new bond ETF will be closely modeled on the existing Ultra-Short-Term Bond (VUBFX) mutual fund and will share a management team. Estimated expenses will be the same as for the Admiral shares of the mutual fund, 0.10%. Similar funds are sponsored by PIMCO, BlackRock (iShares), Invesco, JP Morgan and Janus Henderson—all manage active ultra-short bond ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. with assets ranging from $3 billion to $15 billion or so. Blackrock’s offering charges the lowest fee at 0.08%.
Over the last five years, Ultra-Short-Term Bond has provided investors with a “cash-plus” option, designed to earn more income in exchange for taking on a little more riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline..
The mutual fund version has provided a 10.1% return over the last five calendar years, nearly double Vanguard’s Federal Money Market’s 5.6% return and close to its Short-Term Treasury’s 10.7% gain over the same period, despite taking on only about half the interest-rate risk.
If the fund proves popular, we expect to see Vanguard put other active funds in an ETF wrapper. Its Core Bond fund is a likely candidate to gain an ETF cousin.
Vanguard’s not the only one expanding its active ETF lineup. Fidelity plans to launch four new active ETFs this week, expanding its ETF roster to 37. The new funds will have expense ratios ranging between 0.59% and 0.64%. The firm launched its first three active ETFs in June of 2020.
Fidelity Growth Opportunities ETF
Fidelity Magellan ETF
Fidelity Real Estate Investment ETF
Fidelity Small-Mid Cap Opportunities ETF
Fidelity says the Small-Mid Cap Opportunities ETF will utilize a quantitative approach drawing on data from its small-cap, mid-cap, growth and value investment teams. The other active ETFs are modeled on their like-named mutual funds and will use the same portfolio managers and research teams.
Unlike traditional ETFs, actively managed ETFs do not disclose their holdings daily.
Podcast: Smart Money Moves for 2021
Putting together a comprehensive plan to manage your financial future can seem overwhelming—but it doesn’t have to be. In this edition of The Adviser You Can Talk To Podcast, our team offers some quick tips and tasks that will help you take control of your finances, including action items for:
Managing cash flow and savings
RiskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. management and legacy planning
Managing debt and credit
Income tax efficiency
Whether you’re just getting started with your financial planning or simply need a little fine-tuning, this podcast will help you make your money work for you, click to listen now!
Adviser Investments’ Market Takeaways
There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets.
We hope you find them engaging and accessible, and please let us know if there are any topics you’d like to hear us address by sending an email to email@example.com!
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