Last week a Reddit thread managed to drive up GameStop stock prices specifically aiming to cause a hedge fund to lose billions of dollars. If that sentence only makes a little sense to you (or none at all); then you are not alone. I find most social media posts I read after last week’s events are something along the lines of “I have no idea what happened but I think it is a good thing if this is hurting the rich.” There are so many Wall Street Terms that can be quite confusing but I hope to make them a little easier to understand so that you can achieve “smalltalk proficiency” on the subject.
Some Basic Terminology
If you own a stock, then you have just purchased a tiny piece (called a share) of a company. When a company “goes public” they agree to split the ownership of the company up into shares and sell them to the public. If you own even one share, then you are a part owner of that company. Does this mean you can waltz up to Apple headquarters and demand they let you have a free iPad for owning a share? No. It does mean you have the right to vote on various happenings at the company though so the company will send you information like that via mail.
The Hedge Fund that lost money got into that position because they had Shorted GameStop Stock. Shorting is when you sell stock you do not yet own because you assume that prices will go down. Let’s say, hypothetically, that the latest book is very hot right now and I want to get in on the action and make some coin. I head over to my local library and borrow 4 copies of the book. I carefully peel off the stickers and sell the books to people who pay me for them. When my library loans run out two weeks later, the hype has subsided and I can purchase the books at a lower price than what I sold them for. I buy the books back at the lower price, slap the stickers back on and return them to the library while pocketing the extra cash. That is an example of shorting.
Now let’s say that I sold those same 4 library books, however, when I need to return the books to the library, the books are only available for purchase at a price way higher than what I sold them for because some people on Reddit heard about what I was doing and got the internet to create a shortage of the books. Now I have to spend my own money or pay library fees because I do not have the books to return. That is similar to what happened to this hedge fund.
In order to short stock (selling stock you don’t yet have) you need to have margin on your brokerage/investment account. Margin is a little like having a credit card attached to your account. You need to have enough stock/bonds/cash in your account to have a margin “limit” high enough to buy back the stock you shorted at the current value, or else you will get a “margin call” and be forced to put more money in your account. The hedge fund was not able to meet their margin calls because GameStop’s value went through the roof in such a short time.
A typical phrase when referring to Wall Street is “stocks and bonds,” I have briefly covered stocks so now onto bonds. A Bond is basically a loan that you give; sometimes to a company, sometimes to a town or a certain project. The company etc. (known as the issuer of the bond) decides how much money they need and how much they are willing to pay back in interest first, then they offer bonds for sale. I, as the wealthy investor, purchase bond(s) for a specific amount. If I purchase $50,000 in bonds, then that $50,000 is what I am loaning the company who issued the bonds. In return, the company is going to pay me a certain amount of interest every 6 months and, at the end of the term of the bond, I get my $50,000 back.
Another term that I hear often that is not commonly understood is “stock options.” Typically when you think of stock options you imagine some wealthy CEO who gets a bunch of stock options from a company then rides off into the sunset in a helicopter bound for some private island. Stock options sound very glamorous but are pretty simple as a concept.
A stock option is just a coupon for shares of a stock. Some options (calls) allow you to buy shares of a stock at a certain price. If the price is currently trading at $50 but I have a call option at $10, then I get to buy that stock at my discount. Other options (puts) allow you to sell shares of a stock at a certain price. If I own a put at $15 and a stock is selling for $10, then I can sell my stock at the higher price. Typically you pay for these stock options (or receive them in your big fancy corporate benefits package) so there is some risk of losing money but these can be a way to reduce your risk of loss.
Simple yet complex
While I have done my best to simplify these Wall Street terms in what I hope are layman’s terms, the concepts that I have described here do have more complex considerations when you use them. I recommend talking with a financial professional before starting your own brokerage account or deciding what investments to make. I hope that I could help you better understand some of these terms to aid your future conversations. Thanks!