I’m sure everybody has heard what has been going on with GameStop (GME) and AMC (AMC). This article focuses on GME, but the ideas should apply for all stocks experiencing this event.
To fully understand what’s going on, we first have to understand what a “short seller” is. There are fundamentally two types of investors when it comes to the stock market: “longs” and “shorts.” Most people are longs, but have probably never heard the term. Longs are buyers of stocks, and believe over time that the value of those stocks will go up. When the stock has achieved a value the long believes is fair, they sell the stock and exit the position. A short, on the other hand, believes the price of a stock is too high, and executes this transaction backwards. First, they borrow a share of the stock they think will decrease in value, and sell it on the market. Down the road, when they believe the price of the stock has gone down enough to fairly reflect the value of the company, they return the borrowed share by buying the stock to “cover” their “short” position, and pocket the difference in price.
There are a few things that are important to understand when it comes to going long and short stocks. When you go long and buy a stock, you are doing it with money you have available in your account, and thus can only lose 100%. For example, let's say you have $1000 you want to invest in a $100 stock. If you own 10 shares, and the $100 stock goes to $0, you’ve lost $1000. Stocks, by nature, cannot go into negative prices. By going long a stock you can never lose more than your initial investment. When you go short a stock, you have the potential for unlimited losses. If you take that same $1000 and short a $100 stock, you have just sold 10 shares at $100. If the stock goes up instead of down, you can get into trouble quickly. If the stock goes up to $200, it will cost all of your initial investment to buy the shares back and cover. If the stock goes to $300, it'll cost you $2000 to cover, even though you only invested $1000.
This is where a “short squeeze” comes into play. When you are short a stock, you have to purchase it "on margin" because of the risk of unlimited loss. When purchasing on margin, there are margin requirements your account has to satisfy. Typically, a margin requirement could be 50% of your account - meaning if you have $1000 (like our example above), you could be exposed to $1500 worth of long or short positions. If the price of the stock goes up and you’re short, you have to raise cash by depositing new money into your account, selling other positions, or exiting your current position. As we said above, exiting a short position would require you to buy shares of the shorted stock, which then sends the price of the stock even higher. When short investors begin to buy rapidly in order to exit their position and raise cash to cover their margin requirements, this is called a “short squeeze.” It’s not uncommon to see prices of a stock in a short squeeze move wildly in a day or two relative to its normal price movement.
Enter the group “Wallstreetbets." On the internet message board forum Reddit, Wallstreetbets had a few members who discovered GameStop had 140% of the total available shares sold short. This is highly unusual, and theory should never even happen. But in addition to this, there were very few shares being traded. This unique situation led message board members to conclude that the short traders would not be able to find GameStop shares to buy, other than those absolutely necessary to cover.As a result, members of Wallstreetbets started to spread the word that accumulating long positions at the end of 2020 and into 2021 would force a short squeeze in the stock. The members went long GameStop, and pushed the price from $4-400 in a week. These Wallstreetbets members aren't professional traders. They are everyday people who work full-time jobs. Some have even become so convinced in the trade that they've thrown in their life savings to see it through.
To say this has rattled the cages of Wall Street is an understatement, because on the short side of the Gamestop trade were huge hedge funds. On Jan. 28, the web site Robinhood - which many of these Reddit traders use to execute their stock transactions - limited trading on Gamestop that would only allow users to sell the stock, and no longer purchase. (Robinhood said it did this for two reasons: first, protect the company and its account holders; second, that it was required to do so by clearing firm requirements). This move sent Wallstreetbets, the media, and law makers into a frenzy. Everybody stepped in to defend the “Main Street” retail traders against the "Wall Street" hedge funds that were short the stock, because the trade restrictions allowed the hedge funds to cover their short positions without sending prices soaring higher. We saw AOC, Ted Cruz, and Donald Trump Jr. agree on this issue (and who would have thought we’d ever see those three team up on anything?). Robinhood's move has been called questionable at best, and perhaps even illegal. And to make matters even worse for the company, one of Robinhood’s largest and original seed-round investors just happened to be one of the hedge funds that were short Gamestop stock.
It’s also important to note the Wall Street argument is that the Wallstreetbets message board forum is manipulating the stock market, something Wall Street has long been accused of doing behind closed doors in the Hamptons. While I’m not an attorney, it’s unlikely that any real laws have been broken by this Reddit group, since the laws written around regulating market manipulation were written in 1934 (although I’m sure change will come after this). It's also unlikely that any of the brokerage firms that limited trading on this stock did so illegally.
Nobody knows where this goes from here. It’s likely the brokerage houses that limited trading (there were more than just Robinhood) will face investigations and have to repair their damaged brand. Otherwise, everyone is standing firm on the issue and unwilling to budge. But what's most incredible about this story is that a group of individuals on the internet banded together and effectively shut down some of the most prominent hedge funds around. (Melvin Capital, for example, founded in 2014, has averaged 30% a year returns until this year, where it is currently down 50% one month into 2021. It even required a bailout from another hedge fund). This situation has created a Main Street vs. Wall Street showdown that, to my memory, we have never seen before.
As a last thought, the majority of the Wallstreetbets members, and the rest of the Main Street crew buying Gamestop, are not under the impression that GameStop’s business model is about to turn around and begin to thrive. Gamestop hasn't turned a profit in many years, and have been closing stores for a while. But simpler than that, I think the Wallstreetbets phenomenon has been an exercise of “sticking it to the man,” in which fortunes have been made by everyday people at the expense of Wall Street billionaires.