Gamestop, what happened?

Recently, we have been getting a number of questions about a news story involving the publicly traded company, Gamestop (Ticker: GME), and a website called Reddit. We will use this month’s newsletter as an opportunity to explain this situation, along with some different market mechanics that caused the market to react the way it did.

Background Info

Ryan Cohen, the founder and former owner of Chewy.com, publicly announced in September of 2020 that he would invest close to $100 million in the struggling retailer, Gamestop. Gamestop is a brick and mortar-based retailer that sells video games and gaming consoles. As of late, their business has declined as video games and consoles have become more available online. For the majority of 2020, until Cohen’s September investment, Gamestop’s stock traded at less than $5.00 a share. But Cohen believed the company could be doing better and therefore invested in it in the hope that he could help turn the company around. Upon hearing that a successful entrepreneur like Cohen was investing in Gamestop, many investors began to buy the stock in the hopes that Cohen would be successful and improve the company’s profit and stock price.

Cohen investing in Gamestop to turnaround the company was discussed widely on the popular website Reddit. Reddit is a website that offers users public forums (threads) to discuss different topics and subjects. Reddit’s investment thread known as Wall Street Bets (WSB), is primarily used by retail stock investors who share and discuss potential stock ideas. For the most part, this group’s members are mostly small individual investors who do not intend harm or malice, but instead view WSB as a place where people can help each other make money.

What happened?

Due to Gamestop’s poor financial performance since 2018, Gamestop stock became heavily shorted by large money managers like hedge funds. To short a stock, a speculator would borrow shares of the stock from an owner of the stock and then sell the borrowed shares to someone else. A short sale is essentially betting against a company’s success. Going forward, the short seller hopes the price of the stock drops, so they can buy the stock and return the borrowed shares to the lender. (If you would like to learn more about shorting, please read our explanation below). But, as Ryan Cohen’s investment into Gamestop began to gain popularity, more and more retail investors decided to follow him and purchase Gamestop, with the idea being fueled by places like the Reddit thread, Wall Street Bets. Buying Gamestop became very popular in the WSB thread, with many users viewing this as a David vs. Goliath moment, the small retail buyers versus the hedge funds.

In late January, these adversaries, retail investors (led by WSB) vs. hedge funds, finally came to a head. As more and more retail investors were buying Gamestop shares, they began to drive up the stock price and thus cause a short squeeze. A short squeeze occurs when a stock price rises and short sellers have to either add cash to their account to support their loan of the borrowed stock or buy shares back to cover their short positions. In Gamestop’s case, because the stock was so heavily shorted, the squeeze caused short sellers to cover their positions and thereby further increase the price of the stock. Once the short sellers began to feel the squeeze, it is speculated that other large money managers began to “smell the blood in the water” and also bought large amounts of Gamestop stock, thus adding to the dramatic price increase. Gamestop’s stock price increased from under $20 in early January to high of $450, for a price increase of 2000%+, all within a month’s time.

Due to the high daily volume of trades and volatility, smaller but popular discount brokerage firms like Robinhood, WeBull, and Interactive Brokers began limiting buying of Gamestop stock on Thursday, 1/28/21. The retail investors that used these platforms were not allowed to buy Gamestop shares the entire day, they could only sell out of the positions they owned. However, starting Friday 1/29/21, Robinhood users were able to buy Gamestop on a very limited basis. Days later, after the dust had settled, it had been leaked that Robinhood and other small brokerage platforms limited the buying because these platforms could not handle the risk and trading volume associated with stocks like Gamestop.

Going Forward

With speculative trading like what has occurred in Gamestop, there will be conversations throughout the popular media that the stock market is a casino. In short-term trading, this phrase can be considered true. If you enter the market with a short-term strategy to chase the hottest stock and cash in quickly, there is a fairly good chance you will not find long-term success. However, if someone invests in strong companies, over the long term, they should yield good returns with less risk.

Stock Shorting Explanation

Shorting a stock: To short a stock, you borrow shares from another investor through your brokerage firm and then sell the borrowed shares. Brokerage firms will require you to establish a margin account to facilitate the trade. Covering your short sale entails buying back the same stock and returning the borrowed shares to the lender of the shares. To make money on the trade, the price of the stock has to decrease after the short seller has sold it. The short sheller could then buy back the stock at a lower price and make the difference in price from the short sale and the purchase price. The risk to the short seller is that the stock does not drop in price and the borrower has to buy the stock at a higher price than they sold it for, thus costing them more to buy it back than what they sold the shares for. Besides the risk of the stock price potentially increasing, short sellers also deal with carry cost. When a short seller borrows those stock shares from another investor, they pay interest, similar to a loan. However, the carry cost varies daily and can increase the more popular a stock becomes.

Quick Example: John owns 10 Shares of Apple stock through XYZ Brokers Inc. that is currently priced at $135.00 a share.

Mary believes that Apple stock will decrease in the future so she would like to short it. So, Mary borrows John’s 10 shares through her margin account with XYZ Brokers Inc. and sells them for $135.00 a share.

The next day, if the Apple shares dropped to $100.00 a share, Mary could buy Apple at $100.00 a share and return John’s 10 shares back to him and make $35.00 a share. The total profit would be $350 (10 shares x $35 gain). If, however, Apple’s stock price increased to $150.00, and Mary has to return John’s stock, then she will be forced to purchase the stock at $150.00 a share. By buying the stock at $150 a share, Mary has lost $15 a share for a total loss of $150 (10 shares x $15 loss).