GameStop is a publicly traded retail company that sells mostly video games, mostly at malls. Its stock price has been falling for a while (maybe because malls weren’t really relevant even before the pandemic). But this week, the price skyrocketed and the company became what’s been called “the most traded equity on the planet.”
Many individual investors (aka people trading on their own behalf), many of whom belonged to the Reddit subgroup Wall Street Bets, decided to buy into GameStop at once, driving the price up. This momentum built on itself, especially after Elon Musk tweeted the word “Gamestonk!!” In other words, the stock became so valuable because enough people decided they wanted it to be valuable. The same thing happened to AMC Theatres and a few others, for the same reasons.
The decision to buy into GameStop seems to be a reaction against hedge funds that had “shorted” the company. In other words, hedge fund managers thought GameStop stock would keep going down, so they borrowed shares of stock with the expectation that they could buy them for less money later and pocket the difference. When the Reddit crowd pushed GameStop up instead, some hedge fund companies lost huge amounts of money. This tactic is known as a “short squeeze.”
Why is it happening, and what was going on with Robinhood?
Many of the people doing the trading have said they’re doing it as a show of collective power against the systemic inequalities of Wall Street. Hedge fund managers trade on behalf of elite clients, and often for billions of dollars.
On January 28, Robinhood Markets froze the ability to buy into GameStop and AMC stocks. (Some other brokerage firms also froze trading; others did not.) People could use the Robinhood app to sell, but not buy. Robinhood said it had to restrict trading to meet SEC requirements for net capital obligations and clearinghouse deposits. (That basically means that trading was so volatile they didn’t have enough cash to cover it all.) Shares of GameStop and AMC dropped, jumped after Robinhood announced that it would allow limited buying, and went up again on Friday, January 29.
The freeze triggered an outcry. The thinking is basically that while Redditors and hedge fund billionaires are doing more or less the same thing, one action prompted a freeze and the other is investing as usual. A lot of the outcry centered around the unusual decision to restrict only buying and not selling, which forced the dip in stock prices during the freeze. (The hashtag #DoNotSell, meanwhile, is trending on Twitter.)
What should I think about all this?
A few opinions: Alexandria Ocasio-Cortez and Ted Cruz each called out to let individual traders trade. (And that exchange took on an amazing life of its own, but that’s another story.) The Biden Administration says they’re monitoring the situation. Elizabeth Warren wrote: “For years, the same hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades have treated the stock market like their own personal casino while everyone else pays the price.”
At Ellevest, we’re about making investing available to everyone via balanced, diversified investment portfolios (not just stocks) designed to help you reach your long-term financial goals. Short-term trading is extremely risky — there’s no guarantee any stock will go up (or down) or stay up (or down) at any time, and capital gains taxes or investment losses can be really costly.
We see this kind of short-term investment move as gambling, not investing, so it’s not a service we provide. If it’s interesting to you — either as a form of protest or as a gamble you’re willing to take — remember that you’re working with real money and don’t put in more than you can afford to comfortably lose.
Hedge fund managers were shorting GameStop stocks. That’s a high-risk investment strategy based on the expectation that a stock’s price will go down. To short a stock, you borrow shares from a securities lender (more on that in a sec). That way, you can sell the shares immediately at one price, with the intention to buy them back at a lower price later on. Then you can return the stocks to the lender and pocket the difference. (But only if the stock price actually goes down.) Stocks that have been borrowed, sold, but not bought back yet are known as shorted stocks.
So how does it work to borrow a stock, sell it, buy it back, and then get to keep that money? Securities lending is a way the owner of a stock can make money on their money by lending short sellers (like those hedge funds) the stocks they own. When you do that, you get to charge a loan fee on the transaction and you earn interest from the borrower. Lots of types of stock owners will do securities lending — including many investing brokerages and mutual funds and ETFs (which are both baskets of lots of stocks).
When “shorting” doesn’t work
The hedge funds shorted GameStop, but the price went up instead. Sometimes, if the price goes up, the short seller might be able to just hold on to the stock they borrowed and keep paying that interest, hoping that the price will go down eventually so they can sell it and make money. Or they could decide to just buy back the stock at the higher price, meaning they’d have to pay the difference back to the lender out of their own pocket and take a loss. Or if they sold the stocks on margin (more on that in a sec), the short seller might be forced to take action.
The hedge funds were selling stock on margin. Margin trading allows investors to buy more stock than they have actual cash for in their investing accounts. Basically, it’s a brokerage firm fronting you the money to trade more stocks. (For a fee; this is a way to make money on money.) As an investor, when you trade “on margin” and everything goes as planned, great: You make money. But if the stocks decline, you may get a margin call from your broker. That’s a demand for you to pay them back by depositing more cash into your investing account or selling your stock to cover any losses.
This one’s kind of mind-blowing. You might have read that GameStop had 130% of shares of short interest. That’s the number you get when you divide the number of shares that are short by the total number of shares available. Because those shares are borrowed but then get bought and sold, the person who buys them can ~also~ lend them out to ~another~ short seller to make that sweet lender cash. Those twice-lent shares are called synthetic shares and doing lots of short trading can result in more than 100% of short interest.
The individual investors forced a short squeeze. That happens when a company with a lot of shares outstanding that are short begins to go up in price. That triggers margin calls, forcing many of the short sellers who borrowed and then sold the stock to buy it back at higher prices — the opposite of what they wanted. When there are a lot of those buybacks, it creates more demand for the stock, which drives the price up and up. Short squeezes are nothing new in trading: In 2008, Volkswagen became the world’s largest stock for a time due to a short squeeze. What is new is individual investors coming together via social media to pile into certain stocks.
Call options helped individual investors trade. Options are another way to buy stock. A call option is a contract that gives you the right to buy a stock at a specific price in the future. (Think of it as a way to lock in a price.) Buying a call option is usually cheaper than buying a stock, and the owner of a call option also gets the right to buy 100 shares of the stock — at that sweet price — for each option contract they own. Because they increase your buying power with less money up front, call options were used a lot in the short squeeze buying of GameStop and other companies. Options are a form of leverage trading — ways to trade more without having to buy everything up front.
Putting it all together
“Oh GameStop? Yeah, basically a bunch of individual investors leveraging call options toward a massive short squeeze that forced margin calls on a ton of hedge funds that had shorted it. Can you believe it had short interest north of 130% with all those synthetic shares? Wild.”
Now you can say that AND know what it means.
And now you also understand that the finance industry has about a million ways to make money on money that aren’t even about what a stock is worth due to, um, how the company is doing in the real world and stuff.
The more you know.
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