GameStop and Short Selling

Usually, if I can earn more than a 10% return on my equity investments over a year - fair to say it's been a good year in the market. After all, the S&P delivers around 7% on average every year.

So when my Finance professor mentioned that GameStop stock had risen over 500% since the start of the year, it immediately grabbed my attention. Two days later, #GameStopStock was trending on Twitter and the equity had doubled in value again. What on earth was going on? Short squeeze, bailouts, hedge funds. So much jargon, but what was actually going on?

GameStop - A dwindling business

Video games have been the hype among the youth for ages. In fact, the recent launches of the PS5 and XBOX would probably have you thinking that GameStop - a video game retailer - should be growing well. And the video game industry is certainly growing well, taking advantage of the structural shift to the digital sphere to offer convenient entertainment to many. Yet most of this growth, like most things during the pandemic, has been shifting from physical form to the cloud. And that's the exact same for video games as well, with both Sony and Microsoft releasing disc-less versions of their next-generation consoles.

This naturally has been a constraint on GameStop, with the company steadily declining in revenue over the past few years as more and more gamers take to the cloud for the entertainment needs.

Shorting - Profiting off a declining stock

At the heart of this GameStop story is the role of the massive shorting that was conducted by a number of large US Hedge Funds. Shorting, or short selling, is an equity tool that is effectively a bet on the share price of a stock going down.

It works like this. The shorter, in this case, all the Hedge Funds, borrows shares of stock and sells these to buyers willing to pay the market price. When the stock price would eventually fall, the shorter would buy it back - profiting off the difference. The risk is, however, that if the share price rises, the shorter has to buy the stock back at a HIGHER price than initially sold for - therefore forcing them to make a loss.

So with a declining business model and falling revenue numbers, GameStop became one of the most shorted stocks across the market - with large investors convinced of a negative trend for the stock.

WallStreetBets - The Squeeze

For those of you not familiar with the page, WallStreetBets is a popular subreddit for speculative investors - often humorously discussing the tremendous gains and losses traders are earning.

So when one user of the subreddit noted GameStop's massive short interest, he put forward his thesis to squeeze the short. He argued that if enough users bought GameStop stock, it would appreciate the share price so much that it should force the Hedge Funds into losses. But better yet, because these stocks that were shorted were borrowed - they would need to be bought back and given back to the original owner. This, of course, would mean that Hedge Funds would need to buy the stock - adding to the demand and causing a spiral of growth. This of course was the beginning of a massive fortnight for GameStop stock, rising from $30 USD up to $325 USD in just one fortnight.

The Aftermath

In the aftermath of this bloodbath, there emerged some very clear battle lines across social media. It was retail against institutional, the people against the Hedge Funds, the commoners against Wall Street.

The largest shorter of $GME was a hedge fund called Melvin Capital, which holds an astounding $7 billion under management. It's estimated that after closing their short position in the stock on the 27th of January, the fund lost almost 30% of its valuation and was on the verge of bankruptcy. They were saved however by a $2.75 billion bailout from Citadel, another prominent hedge fund.

Melvin Capital was notorious across the world in 2020, as they were also one of the largest shorters of Tesla stock - a company that rose 560% in 2020. This prompted a notable tweet from eccentric Tesla CEO Elon Musk - "Gamestonk!!" - as a form of getting back at the hedge fund which underestimated the manufacturer of Electric Vehicles.

Ultimately, this battle between retail investors from r/WallStreetBets and Hedge Funds has prompted a wider discussion of the extent to which the free market should be allowed to operate. Undoubtedly, had collusion of the sort we saw on WallStreetBets have taken place across trusted financial companies - lawsuits of price manipulation would be being handed out all over the place.

We saw it in 2008, and we're seeing it again in 2021 - financial bailouts for careless corporations placing a real constraint on the natural flow of the free market. These hedge funds need to be taught their lesson, and a lifeline certainly won't further that.

It's a financial story to tell your grandchildren - that you were alive when GameStop stock flew 1700% because of some guys on an online forum. For now, though, let's sit back and watch as GameStop's stock flies to the moon 🚀.