GameStop Stock Fiasco Explained

GameStop, a dying video game retailer, has blown past epic proportions to the point of hitting all-time highs in the stock market.

A few weeks ago, the company (stock trading as ticker: GME) traded around lows of ~$19. As of January 27th, 2021, the GameStop stock has reached an all-time high of $350. That’s a ~1700 percent increase! Currently, GameStop’s market capitalization is $24 billion, previously $500-$700 million.

Before its euphoric rise, GameStop was on a slow demise to bankruptcy, as it faced significant challenges to its business model from the internet. Similar to BlockBuster, people stopped buying video games in-person at retail stores. “Downloads became a thing, and GameStop’s business declined,” says Michael Pachter to BusinessInsider, who covers the video game industry.

Alongside GameStop’s faltering business model, GameStop also ran into issues with its poor business decisions. They embarked on new initiatives, including the acquisition of Spring Mobile in 2013. The company had bet on making money by buying smartphone stores. By 2016, GameStop had owned and operated approximately 1,500 mobile-phone stores under the Spring Mobile name, and in 2018, had sold the whole mobile-phone business.

So how did GameStop rise from the ashes?

Well, A Trading Euphoria Caused By …

An army of traders from the Reddit r/WallStreetBets has been at the center of the GameStop saga. WallStreetBets (WSB), a community of Millennial and GenZ traders, have helped drive a to-the-moon surge of GameStock’s stock price while halting trading multiple times, crashing Reddit, and even forcing the subreddit to go private. With 3.5 million traders following the subreddit, WSB users are known for purchasing extremely risky products, including leveraged ETFs, financial call and put options, as well as shorting equities.

These Reddit users have blown everyone’s expectations out of proportion. No one expected a group of online traders would have a massive effect on the stock market.

Most notably is perhaps the loser of this David and Goliath saga – Citron Research and Melvin Capital. Both of these investment firms took huge bearish bets against the GameStop stock, and even Citron had announced on Twitter that “GameStop buyers at these levels are the suckers at this poker game.” For those of you unfamiliar with stock trading, the two firms had shorted the GameStop stock by borrowing the stock to sell at a given price, with the idea that they will purchase back the stock later.

In this case, assume an individual sells short one share of GME at $19 in their margin account. What happens is they receive $19 from selling the share on the stock market, but they still owe their broker one share of GME. So, in this individual’s ideal scenario, they will want to buy back GME at a lower price to profit on the trade.

But in this trading saga, Reddit users had driven up the price by buying so much. Hence, increasing GME’s stock price. So, the individual holding the short position would have to purchase the stock back at a much higher stock price on the settlement date; thus, losing money.

The Squeeze

Due to the rampant rise in GME’s stock price, Citron Research and Melvin Capital had been taking on significant losses, and with due time, they would eventually have to close their position. Closing their position would squeeze them out of their position. For a short squeeze to happen, the firms’ losses have to be so high that the broker requires more capital to keep the position open. As of January 27th, both firms have closed their positions. Since then, hedge funds Citadel and Point72 have invested $2.75 billion into Melvin Capital.

The Question Still Remains – Why Did r/WallStreetBets Target Melvin Capital and Citron Research?

Greed has been present on Wall Street since the inception of the securities market. During the 2008 financial crisis downturn, banks were giving loans to anyone to make more and more money while selling mortgages to poor credit individuals. Their greed eventually reached a point where many homeowners could not make their mortgage payments causing foreclosures, and eventually, a recession. In the end, the banks received a bailout, and similarly, Melvin Capital received a bailout from other hedge funds.

In this ordeal, the two hedge funds shorting GME had become too greedy as they had driven GME’s share price from $20 to $10 and to $4. There was no means to an end for their greed and their hope for GameStop to go bankrupt. In part, short selling wipes out businesses. Elon Musk has also laid criticism to short-sellers, tweeting “short-sellers are jerks who want us to die.”

So, how does greed tie together with shorting a stock, hedge funds, Reddit users, and a video-game selling retailer?

Well, someone on WallStreetBets had noticed these hedge funds had sold short 140% of all shares available. The rule to short-selling is that ALL the shares they borrow MUST be paid back. Realizing these hedge funds had shorted GME by a ridiculous amount, these retail investors on Reddit (ordinary people like you and me) bought every share they could get their hands on. Thus, driving the price up like crazy and perhaps creating an arbitrage opportunity.

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Why?

These hedge funds would eventually HAVE to buy back these shares at whatever price they could purchase. They don’t have a choice. So, these Redditors bought all the GME shares they could buy and drove the prices up to ridiculous prices. Buying back these shares of GME would cost these hedge funds an arm and a leg.

Fast forward to today, January 27th, 2021, WallStreetBets users are creating memes, as well as notable people, including Elon Musk and Chamath Palihapitiya, who have influenced more people to buy GME stock. Hence, destroying these greedy hedge funds in the process.

Additionally, many Redditors felt crude sentiment towards these financial institutions as numerous Reddit posts complained about these institutions’ predatory actions. Even AOC tweeted, “Gotta admit it’s really something to see Wall Streeters with a long history of treating our economy as a casino complain about a message board of posters also treating the market as a casino.”

Notable People’s Influence Behind The GameStop Stock Rally

As it’s been interesting to watch GameStop’s stock rally, there have been notable individuals placing their own opinion. Michael Burry, best known from “The Big Short” as one of the investors who had made money from the 2008 financial crisis, had been holding onto GameStop since 2019. Although he has a 2.4 percent stake in GameStop as of Sept 30, 2020, he has stated, “there should be legal and regulatory repercussions. This is unnatural, insane, and dangerous”.

Contrarian Chamath Palihapitiya has also played a part, as he tweeted his purchase of $125,000 out of the money call options on GameStop.

For those unfamiliar with call options, call options are a financial derivative used to make speculative bets on the rise or fall of stock prices. In this case, Palihapitiya made a speculative bet for the increase of GameStop stock.

Elon Musk, well-known for the tweeting habits that have gotten him in trouble with the SEC, has also taken part in the GameStop rally by tweeting a subtle “Gamestonk!!”

How Does Reddit Feel About This?

Reddit’s r/WallStreetBets have broken all-time traffic records this week as millions of visitors flocked to the subreddit. According to Mashable, r/WallStreetBets received approximately 74 million page views in the past 24 hours. Note, Reddit had 52 million daily active users in October 2020.

One WallStreetBet moderator felt compelled to address the backlash with the narrative that the forum “is disorderly and reckless” and is involved in manipulation. He wrote, “What I think is happening is that you guys are making such an impact that these fat cats are worried that they have to get up and put in work to earn a living.”

Can Regulatory Bodies Do Anything?

The trading activity on GME reminds me of the old pump and dumps that ultimately harmed many traders. The stock gets hyped up way out of proportion to its actual intrinsic value and essentially benefits the ones who are hyping it. Will the stock really retain its value over the long haul? If not, then the people who heard the hype and came late to buy it could suffer. – Eric founder of Mindful Trader

As the trading volatility ensues, regulators are becoming increasingly worried about all the signals this volatility is sending to traders, like TD Ameritrade and Schwab. Both brokerages have restricted certain kinds of trades in GameStop and AMC. TD Ameritrade said there was “an abundance of caution amid unprecedented market conditions and other factors.”

Regulators have been mindful of the action, as William Galvin, Massachusetts secretary of the commonwealth, told Barron’s that he was watching the story play out.

Regulators do monitor trading for any signs of market manipulation and what people say about stocks in public forums, according to Amy Lynch, a former SEC regulator. However, merely announcing to people that you are buying a specific stock and telling people they should as well have no legal repercussions.

The End of the GameStop Saga?

Ultimately, the GameStop saga has not run its full course, as trading is still occurring for the crazy stock. But, the two hedge funds that started all of this? They are entirely out. One hedge fund has wholly gone bankrupt, and other hedge funds have funded the other hedge fund. Will we be seeing this hedge fund enact vengeance on these Reddit users? Most likely not.

The takeaway we can all get from this whole ordeal is don’t mess with Reddit users, and perhaps the next generation of Millenials and Gen Z have more impact than we imagined?

This post originally appeared on Wealth of Geeks