The story of the astronomical rise of GameStop share prices and the subsequent buy halt by Robinhood caught global attention. Although it wasn’t the only one that witnessed the buying frenzy from small retail investors, GameStop is by far the most peculiar one, with its share price rising over 2700% within two weeks.
Now, let’s understand the story of Reddit users vs billion-dollar hedge funds.
What is GameStop?
GameStop is an American brick and mortar retailer of video games and other gaming merchandise. Its shares are listed on the New York Stock Exchange and NASDAQ.
Share trading involves buying and selling of shares listed on a stock exchange via an intermediary – a brokerage firm. Typically, brokers charge a small fee for matching your trading orders. However, Robinhood managed to gain popularity among day traders since it didn’t charge any fees. Every cent counts, right?
When a company performs well or has rosy prospects, its share price rises; and falls when its future is bleak, the latter was the case with GameStop. As a brick and mortar store, GameStop’s market share and existence were threatened by e-commerce.
Hedge Funds and GameStop
GameStop’s bleak future prompted massive short selling by hedge funds. Here’s how short selling works. Short selling involves borrowing shares and selling them, with a promise that you’ll buy them back in future, hoping that prices will be lower.
The major flaw with this strategy is that if the price of that stock increases, your potential losses could be unlimited since you’ll have to buy them back at a much higher price. That is why brokers often demand a margin payment meant to cover potential losses. When the price of the stock increases, the broker will require you to increase your margin.
For GameStop, about 130% of its available stock was shorted. This is dangerous since there are no more stocks available for shorting to counter any dramatic increase in prices, as was the case when the Reddit contagion spread.
Reddit Contagion and GameStop
Typically, when large hedge funds take a significant short position, they often use public opinion to their advantage. They do so by highlighting flaws in the company, which drives the public to dump the stocks driving prices down. However, this strategy backfired when it came to GameStop.
For many, the short play on GameStop was a no-brainer. In an era where you can download or play any video game online, profits for a predominantly brick-and-mortar would take a hit. This wasn’t the case, though. Thanks to the 2020 lockdown, GameStop had a jump in online sales for pet supplies. At the end of 2020, its share price crossed the $20 mark for the first time in three years. That’s when a Reddit user pointed out how badly the company’s stock was overly shorted and primarily by hedge funds.
It gave rise to a series of “call-to-action” posts for Redditors to rise in arms against the hedge funds. This fuelled a buying frenzy by hundreds of thousands of small-scale retailer traders who sent stock price surging. Most of the buyers got in not with the primary goal of benefiting from the long trades but to punish the institutional traders in short positions. To them, this was revenge for the financial meltdown of 2008. And punish they did!
As we’ve mentioned, the price of GameStop shares surged from $20 on January 13, 2021, to $508 on January 28, 2021. This resulted in margin squeezes for those in short positions and an estimated $23.6 billion in losses for the hedge funds.
With the advent of technology, you can now easily get into stock trading because all you need is smartphones, an internet connection, and a few bucks to get started. We wish you luck. Cheers!
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