Several
government entities in the United States are looking into the recent volatility
of stock prices for the company GameStop (GME) as well as the decision made by
brokerages like Robinhood to restrict the trading of GME stock. The question is
if there was any market manipulation involved by the traders and if brokerages
had complied with federal regulations. How did we get here, what exactly
happened and what happens now? Let’s break it all down.
This story
beings on the Reddit forum WallStreetBets. A forum where every day retail
traders gather to exchange information and tips. The members of the forum
noticed that many wall street hedge funds were shorting the stock for the
company GameStop. The retail traders decided to collectively invest in the
company as a way to make money and give the proverbial middle finger to massive
hedge funds. The decision by these investors to buy the stock triggered what is
referred to as a short squeeze. At one point the price of GameStock shares soared
to $483, up by more than 2700% from $17 at the start of the year. Currently, the
shares are priced at $52.
What is
short selling or shorting?
Shorting is
a trading concept where an investor bets on the price of a stock falling to
make a profit. Short traders will borrow stock from another trader and sell it when
the price is high. Once the price drops, they buy the stock back and return it
to the person they borrowed it from. The difference in price is pocketed as a
profit. Imagine that there is a Company A whose share price is currently $10; trader
Joe knows that Company A is not doing well, or strongly believes that the price
of Company A’s shares are going to drop, so trader Joe borrows 10 stocks in
Company A from trader John. He immediately sells the stock at $10 and earns $100.
As predicted the stock price then drops to $7. Joe buys 10 stocks back at $7,
spending $70, and returns the stock to John. Joe earns $30 as a profit.
Why did Redditors
choose GameStop?
GameStop is
a brick-and-mortar chain that sells video games. As streaming services and
online retailers have entered the space, GameStop’s business has been faltering.
The situation is only expected to get worse. Think, Blockbuster as Netflix
started to gain popularity. For a few years now Wall Street hedge funds have consistently
bet against GameStop’s shares and earned a profit.
At the height
of its popularity between 2012-2016, GameStop was a popular destination among
gamers. In 2012 the company earned a revenue of $600 million. Many from Reddit’s online community have a soft spot for the company and good memories of
visiting their stores. This may have sparked the interest in the firm’s shares
by the amateur investors.
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Did
wall street lose money on GameStop?
When the Redditors
decided to collectively invest in GameStop shares, they drove the price of the
shares higher. This triggered something called a short squeeze. As the price of
GameStop increase, investors who had bet against the stock had to quickly buy
it up or risk losing even more money if the prices continued their upward
trend. As short traders buy up the stock to forestall further losses, they
drive up the prices even more. Let’s look at our earlier example again, Joe
borrowed 10 stocks in Company A from John. He sold them at $10 hoping the price
would fall and he could buy them back cheaper. He has to return that stock to
John. Imagine, if instead of falling to $7, the price increases to $13. Now Joe
has to pay $130 to acquire the 10 stocks he has to return to John, this means
he will lose $30. Joe could choose to wait longer and see if the price falls again,
but he also risks that the price might increase even more.
The move by
amateur investors on Reddit was unprecedented. Initially, the general perception
was that wall street had lost a lot of money due to GameStop and that small
investors had managed to get one over the institutional investors and earned a
profit. However, as more information has been gathered, experts believe that
the volatile trading around GameStop may actually have benefitted big players
in Wall Street. There are some hedge funds that had to pay for shares at a
higher price to cover their short bets, however as the price started to trend
higher, other hedge funds may have taken calculated risks to earn a profit from
the volatility. Former economic advisor to President Bill Clinton, Robert J.
Shapiro said, “You have hundreds of millions of shares being traded at prices
of $200 to $300 a share,” Shapiro said. “The Reddit crew cannot afford to play
in this game in any significant way.”
Redditors
on the other hand, have not stopped at GameStop, the amateur investor community
has chosen to pull the same trick with other companies that they believe Wall
Street shorted. These include the likes of Bed, Bath and Beyond, Blackberry and
AMC theaters. The question of who ended up earning a profit during this entire
saga will be of import to the government entities that are investigating the
situation.
What role
did Robinhood play?
Robinhood
is a stock trading and investing app. The company positions itself as an app
for the masses and its mission is to democratize the financial market. At the
height of GameStop’s stock volatility, as some hedge funds were reporting massive
losses, Robinhood made the decision to restrict the trading of GME stock. Users
would only be able to sell their shares and not purchase them. This decision did
not sit well with app users who believe that the company ultimately acted to
protect Wall Street’s institutional investors. Many other brokerages also
decided to restrict trading in the stock. Retail investors have cried foul and
class action lawsuits have been filed against Robinhood, with many choosing to
take their money elsewhere.
What
happens next?
The US Senate
Committee on Banking will hold a hearing to discuss, ‘the current state of the
stock market.’ The hearing is being called, ‘Game Stopped? Who Wins and Loses
When Short Sellers, Social Media, and Retail Investors Collide’. Reddit CEO
Steve Huffman, Robinhood co-CEO Vlad Tenev as well as some prominent Redditors
from the Wallstreetbets forum will testify at the hearing.
Meanwhile, Hollywood has jumped on the story
with both HBO and MGM announcing plans to make a movie. Netflix is making both
a feature film as well as a documentary and there is even talk about creating a
TV show around the situation. Whether or not any regulatory changes are made
following the senate hearing remains to be seen. One thing is for certain, the
investment world has fundamentally changed.
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