Published: - Aug 08, 2018

An investment fund used this mechanism to enrich itself with a supposed failure of Nintendo in the Tokyo stock exchange. How does it work and why did they do it?

Last week, the investment fund Melvin Capital Management put 400 million dollars on the line, betting on the failure of the gaming giant Nintendo in the Tokyo stock exchange. Using a mechanism known as short sale, Melvin Capital can be enriched through a fall in the price of Nintendo shares. This may sound ridiculous, but it makes sense, since it works very differently from the purchase of stock.

A short sale is a bet against the performance of a company in the stock market. It is a risky way to take advantage of a fall in the price of an action. Generally, they get the attention of investors and receive good coverage, because the risk that comes with a short sale makes it exciting to follow up.

This is how a short sale works

When you buy stock as an investment asset, their prices are expected to rise, so you can sell them later with a profit margin. However, the opposite occurs with the short sale. The success of the short sale, for those who carry it out, depends on the fall in the price of the stock, the greater the fall, the more it can earn.

1. If an investor believes that the shares of a company will fall in the future, he can manage a short sale through his stockbroker. The investor then decides on how many stocks the short is going to make, and the broker gets him, usually within the portfolios of his other clients, that number of shares in the form of a loan.

2. Suppose then that an investor wants to make a short on a single stock of company X, which at this time costs $ 100 dollars. The broker seeks that action within his clients' portfolios or inventory and sells it on behalf of our investor at the current price, which means that the investor now has $ 100 dollars in his name.

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3. If the stock price of company X goes down, say, up to $ 70 dollars, our investor's short was successful. With the 100 dollars, which he has in his name from the initial sale of the stock, the investor buys one of the shares at the current price of 70 dollars, which will be returned to its original owner, covering the loan.

4. At the end of the process, the loan of the share was covered, and our investor has 30 dollars, the difference between the initial price of the share and the end, in his account. This figure goes, on the one hand, to the compensation of the broker for taking the risk of the loan, and on the other hand, the rest remains as profit for the investor.

A high-risk move

A short involves much more risk than the purchase of stock, mainly, because the losses can be unlimited while the profits are limited. In the normal purchase of stock, the maximum that an investor can lose is 100% of the price paid by the action, something that would happen if the price fell to 0. However, the gains are, in theory, unlimited, since there is no upper limit that determines how much the price may rise.

In a short, it is totally the opposite. The maximum an investor can earn is 100% of the price he paid for the stock, in the event that the price of the stock falls to 0, while the potential losses are, in theory, unlimited, because the higher the price rises of the action, the more the investor loses, and there is no limit that determines how much it can rise.

400 million say that Nintendo will fail

Gabriel Plotkin, owner of the investment fund Melvin Capital Management, made a short of 1.2 million shares against Nintendo, convinced that stock will lose a significant part of its value in the near future. The total at stake is 400 million dollars, 0.8% of the total shares issued by the Japanese company.

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Yuji Nakamura, Bloomberg analyst, commented on the risky move of Melvin Capital Management. "The poor performance of the action has dominated the coverage in financial and video games, in addition to the discussion on social networks, which has triggered doubts among long-term shareholders who begin to lose faith in the performance of the console Nintendo Switch", says Nakamura.

"Investors have been surprised by the sudden fluctuation of Nintendo's stock, and Plotkin's position should add to their concerns", he added.

The performance of the Nintendo stock since Melvin Capital Management made the short seems to indicate that Plotkin can emerge victorious. Although the year 2017 was excellent for Nintendo, selling 17.8 million units of the Nintendo Switch, exceeding the predictions of just 15 million, this year brought problems for the company's stock. Investors fear that the sales of the main console of Nintendo will not be maintained due to an abandonment in the accompaniment of the brand to the console, as no high-profile releases that bring more attention to the console have been announced.

The situation of Plotkin, who made the short on stocks that cost between 41,000 and 42,000 Japanese yen (368 and 377 dollars), is still pending. For now, it seems to stay in contention, as the stock was quoted on August 6 at 36,890 yen (331 dollars), but could still recover through a good performance in the last quarter of the year, which includes the very lucrative holiday dates.

LatinAmerican Post | Pedro Bernal

Translated from “¿Qué es un short sale y por qué apostaron 400 millones de dólares al fracaso de Nintendo?”