GameStop: A Case Study
What does it mean to short a stock?
Ever since my childhood, I’ve been fascinated by money. When I was introduced to the stock market by my father, an occasional fundamental trader, I was intrigued beyond words. So, this year, when a community on Reddit famously manipulated GameStop shares, I was happier than I’d ever been to see a fresh form of volatility in the markets.
For those of you who are somehow oblivious to this incident, this article is for you. And those of you who’d like a deeper analysis into this incident, although you’ve heard of it, this article is for you too.
You may be wondering why I’ve decided to write about this now since it’s considered pretty old news in our fast-paced world. However, I’ve had so many conversations with peers and family members, and it’s apparent that there isn’t a solid universal understanding of the functioning of the stock market, especially when it comes to being short in an asset. Hence, this article aims to close that gap.
Introduction
The subreddit r/wallstreetbets was created in early 2012 as a forum for discussing high-risk investments in the stock market. In early 2021, WSB members noticed GameStop stock being undervalued. They realized a great number of shares were being short and, thus, decided to trigger a short squeeze. Before we get into the crux of the incident, let’s discuss what short selling is.
Shorting a Stock
In principle, shorting a stock or short selling a stock is a form of investment where the investor profits with a drop in asset value.
It is the opposite of regular stock transactions you often hear about, known as going long. While going long, investors profit with the appreciation of their assets.
How exactly does this work?
Let me paint you a picture to help you understand the most fundamental method of achieving a short position.
Imagine a lender has 100 unsold shares of a certain company at a price of US$10 per share. You, an investor, decide that the stock isn’t worth its price. No investor would buy shares to an asset they think will depreciate in value. So, you decide to short the stock.
When you short the stock (let’s say you short all 100 available shares), the lender is loaning you the 100 shares (often while levying a lending fee), which you then sell to an investor looking to buy shares in this company. Now, you’ve made US$1,000. But you aren’t the owner of the shares; you’ve only been loaned them by the lender, so the transaction is not complete until you repurchase the shares and return them.
Let’s say over a period of two months, the price per share drops to US$7 per share. If you decide to buy the shares back (at the current market price, of course) and return them to the lender, you will have paid US$700 to close your position.
Looking at your net profit, we have US$1,000 - US$700 - lending fee = US$300 - lending fee.
That’s what short selling is in a nutshell.
What are the risks involved?
Let’s start with the risk involved for the investor. It’s fairly simple to say the risks involved are potentially much greater going short than going long. This is because while going long, the most money you can lose is 100% of your principal investment, whereas while going short, you can potentially lose everything. I don’t mean everything like 100% of your investment; I mean 100% of everything you own, and then some. So while going long is risky enough, short selling stock has a far greater potential loss.
Joe Campbell had his short position crushed when share prices went up 800% while he slept. A man who went to sleep with an E-Trade account balance of about US$37,000 woke up in over a hundred grand of debt.
Now let’s move on to the risk involved for the lender or broker. On the one hand, the short seller is doing the lender a favor by taking the risk of market volatility into his own hands by bearing the brunt of potential losses.
On the contrary, the broker now has a credit risk. The way short selling works, the broker must first procure the shares for the short seller to sell. The short seller will eventually return the shares, but to fill the deficit in credit, most brokers require short sellers to maintain a margin account, where they pay an interest based on the size of their position.
Why does short selling exist?
We’ve gone through how risky short selling can be and how much more complicated it is than going long. This brings up the question of whether short selling really deserves to exist in the first place. Some say shorting stock may even be unethical. Nevertheless, here are a couple of compelling arguments for why short selling needs to exist.
- Tim Worstall points out that short selling can be used as an incentive to uncover fraud. This makes an enormous amount of sense. For example, let’s say we have an overvalued company that you suspect is fraudulent. If you short sell its stocks and expose the company, share prices are bound to plummet, and you cash in your profits once you repurchase.
- Investopedia shines a light on how short selling can keep inflation in check. When a security is overvalued, investors will hesitate to purchase it at its market price. A short seller could help drive the price down to its true value, at which investors would decide to go long again.
These aren’t the only reasons short selling exists, but they do give us a better perspective.
Now let’s get back to the GameStop short squeeze.
How Redditors Profited Off of Short Sellers
When the WSB community members on Reddit realized that the value of GameStop shares was heavily undervalued, they found out that several large hedge funds had shorted their stock.
GameStop is a brick-and-mortar video game store, which had been struggling for quite a while against its digital competition, and it was further hit by COVID-19, reducing its sales figures. This led the large corporations to short sell GME stock, in a sense betting on prices to go down further. In fact, in January of 2021, 140% of the public shares had been sold short, which means some shorted shares had been shorted again.
Now, investments in GameStop by the likes of Ryan Cohen and Michael Burry led some to believe the stock was undervalued. So, the word was spread, and people started buying GME in large amounts to squeeze the hedge funds and potentially make a profit in the process. Even Elon Musk weighed in.
To be real here, Elon Musk is a very, very influential man. When Elon joked that he’d send a Dogecoin to the Moon, it resulted in an almost immediate 32% jump in $DOGE value. So you shouldn’t be surprised to hear that his support of the WSB community’s movement only led to share prices soaring higher.
Some community members were keen on making a quick buck, so when prices saw a record growth of over 1,800% in less than three weeks, many cashed out with immense profits.
But others were motivated by opposing the hedge funds rather than the profit. They knew that the large short-position holders would be required to buy back the shares to clear the position, so community members decided to buy and hold. This way, there wouldn’t be any shares for the hedge funds to clear their positions, which only led to bigger losses. Short sellers lost an estimated US$6 billion due to this movement.
The fourth week of February brought yet another push of almost a 500% increase over a three-week duration. The share price continues strong as I write this article, and it looks like the WSB community isn’t going to let it fall any time soon.
Aftermath
The immediate response to this movement was fairly positive. Around the world, people were taken by the Robinhood-like phenomenon, where the ordinary people stood up to huge corporations. Even some hedge funds acquired long positions in GameStop during its growth.
Some brokerages, particularly app-based Robinhood (ironic, right?), halted buying GameStop shares immediately after the first peak on the 27th of January. They cited an inability to execute orders due to insufficient collateral, but they were still criticized and accused of market manipulation. They face dozens of class action lawsuits.
As prices began to fall, some Redditors lost out on hundreds of thousands of dollars by holding stock, but their message was clear. They wanted to continue squeezing short-sellers.
Conclusion
The chairman of the New York Stock Exchange said the run-up in GME shares highlights some of the inherent flaws in the stock market. The incident shows us the democratization of the markets. It also highlighted a paradigm shift in the attitude towards day trading, showing us that individual investors didn’t have to remain silent in a market largely influenced and manipulated by retail traders.
But it’s important to note that trading is no game. Only 10% of individual investors make money. Even when it comes to GME, many people invested too late and too heavy, and no matter how coordinated of an attack this was, there was no denying its unpredictability and risk.
If you read all the way, thanks! If you have any suggestions, feel free to leave a response.
