GameStop: a game changer?
Much coverage has taken place in the media in recent weeks about the ‘shorting’ of GameStop Inc. I have had a number of discussions with clients about the situation and I think an explanation would be in order.
As a trader on the stock market, you generally choose a stock you think is likely to go up in value in the future. You buy it and, when it does go up, you sell it and make a profit. But what does ‘shorting a stock’ mean?
Shorting (or short-selling) is when an investor borrows shares and sells them, hoping he or she can scoop them up later at a lower price, return the borrowed shares to the lender and pocket the difference. Instead of buying and then selling, you sell and then buy. It is public knowledge that various companies have ‘shorts’ on stocks and, when hedge funds are short-selling, they must declare it to the public.
GameStop, a bricks and mortar retailer in the USA selling video games, was a prime target for short sellers. The pandemic hit GameStop hard with their stores closing and the stock price was really struggling. However, hedge funds shorted the stocks expecting them to fall and make them a large profit. As is usual practice, some short sellers put out press releases declaring their intention, convincing people there was an issue with the stock, in their opinion. In doing so, encouraging traders to sell the stock, creating a self-fulfilling prophecy and lining their pockets. But this time, users on the Reddit message board had other ideas and GameStop became the focus of a trading war between amateurs and Wall Street professionals.
Short selling is legal and relatively common, but there is great debate as to whether it is ethical. Hedge funds are basically making money from companies that are failing and, in effect, can be seen as contributing to their demise. The aftermath of their gain can lead to job losses and creditors not getting paid. Reddit is a social network of online forums where individuals can create posts about shared interests and interact with other members of the forum. One of these forums, known as Wallstreetbets, started the year with around 1.75 million users, now has over 8 million.
A member of the forum posted a message that they believed the hedge funds’ collective short interest exceeded 100% of the available shares and to encourage the community to buy GameStop shares (and call options) to see whether, through the power of people, they could fight back against short sellers and make them (the Hedge Funds) suffer a loss. As a direct result, GameStop’s stocks gained almost 1,800% in January 2021 and short sellers, having no choice but to close their short positions, suffered billions of dollars-worth of losses. Conversely, the Wallstreetbets forum was full of screenshots of investment accounts with multimillion-dollar gains and users egging each other on to continue buying up the stock.
Hedge fund, Melvin Capital, became a target after the firm disclosed its bet against GameStop in regulatory filings. Melvin Capital reportedly exited its bet against GameStop, losing in total around $3.75 billion. They were not alone, another high profile short-seller, Carson Block from Muddy Waters hedge fund, also sustained heavy losses. The result of all this was that amateur traders effectively pushed the share prices up and the hedge funds were forced to close their ‘short position’ which created even more buying pressure on the stock, pushing it to extreme levels.
I think it is fair to say this is a clear example of how a new army of day traders have effectively ‘weaponised’ financial derivatives to their advantage and, not surprisingly, the Reddit community has attracted serious attention and is gaining hundreds of thousands of new members each day!
Now, has the fight back made a difference? Well, the implications are that retail investors have a lot more power than markets previously thought, but there is a question mark over whether this action is also a form of market manipulation. This type of mass campaign creates huge gains and losses and it is as easy as a post on a forum. Members of the Reddit movement will have made millions of dollars in the process of making the hedge funds pay and some of the platforms are trying to limit this type of trading.
Robinhood (one of the largest retail platforms in the USA) stopped traders buying shares to protect their interests, claiming serious damage can be done when traders do not understand their position. However, lawsuits are now being proposed against Robinhood on the Reddit forum. What a mess!
If we are saying it is wrong for the Reddit community to encourage mass buying of stocks, surely, it is not right for the hedge funds to profit from shorting either? Some say the ‘short squeeze’ (this is the phrase given to what has happened) suffered by hedge funds is a victory over the broken system. The power of the retail investor is clear, but will this ‘warning shot’ stop shorting in its tracks? Well, maybe it will in the short-term, but does the system need to change to protect our assets and encourage growth rather than preying on the weak?
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