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Gamestop Explained: Short Squeeze, Reddit Vs. Hedge Funds

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

Quick Summary of Events So Far

Everyone who has seen The Big Short has an idea of what short selling is: betting against a stock or market, with the hopes that if the price drops, you'll make a ton of money. Understanding the specific mechanism of how a short happens is important in order to understand what happened with Gamestop stock in January of 2021, so we'll take a look at that here. The events, as they have unfolded, are roughly thus:

  • Reddit users on a forum called WallStBets noticed that there was a lot of short-selling for Gamestop stock, a nostalgia-favorite for a lot of users.
  • The users decided to organize a short squeeze (see the description below of short selling and a short squeeze) in order to force the short sellers to have to close their short position and lose a lot of money.
  • As the short squeeze gained momentum, Wall St. and Main St. took notice, and the Reddit users and other retail traders were quickly framed by the media (social and otherwise) as "the little guys" taking it to the hedge funds, in a battle clearly destined to pull on populist heart-strings.
  • This perception was amplified as Robinhood and other trading apps temporarily shut down, or limited, their users' ability to purchase Gamestop stock, while keeping the option to sell open.

Is it all so cut-and-dried? I don't think so, and here's why.

What Is Short Selling?

In essence, short selling is borrowing a stock you don't own from someone else, immediately selling the share of stock you don't own, and then waiting to buy the stock back, hopefully for less than you bought it for initially. You'd walk away with the difference, minus brokerage fees. Now imagine the stock price doesn't drop, as you anticipate, but instead goes up. If you buy back the shares when the stock is up, you would lose the difference. Here, you can immediately see that short-selling has an asymmetrical downside: the most you can "win" is 100% of your money, but your losses can theoretically be infinite, if your stock just keeps going up. When someone shorts a stock, they are always borrowing the share from someone else, usually a broker. The broker holds the share as collateral when the short-seller opens their short position, and they will ask for a percentage of whatever the stock is worth to be held in a margin account, just in case the short-seller isn't able to cover whatever the stock is worth.

Short Squeeze

Why would anyone shorting a stock buy it back when the stock is going up? One main reason is leverage. If a person is shorting XYZ stock, and it goes up 100% today, then the short seller may get close to not having enough cash in their account to buy back the shares if the actual owner wants their stock to be returned, so the brokerage might ask the short-seller to double the amount of money they have in their margin account. If they can make the payment to the margin account, then everything's fine. If they're unable to make the payment, the broker will force the short seller to buy back the stock at that time (take the loss). This is one way short sellers are forced to buy back their shorted shares, even when they're going up in the market: because they have no choice but to buy in order to meet the margin call. Incidentally, Margin Call is another fun movie to watch that helps break down a concept that's useful for understanding today's situation.

Good vs Bad

A large portion of the country (and even the world) seem to have regarded this as a very clear battle between the good guys vs the bad guys: the WallStBets crew, who represent "team good," vs the bad baddies over at Hedge Fund Central, who represent "team bad." Now it does seem like the WSB crew is trying to make some kind of a moral stand vs Big Capitalism, but I think it's a lot more complex than that, and for a variety of reasons.

First, WSB is far from a homogeneous paradise of progressive thought. There's plenty of misogyny, homophobia, and racism deeply embedded in the culture of the forum. No, not everyone on there is like this, but the behavior is not only tolerated; it's 100% encouraged and applauded by large swathes of the community. Yes, they have some really funny individuals who come up with "dank memes" (really, truly funny shit), but they also have a lot of very dark, sociopathic reactionary types. So, not exactly the real life representatives of Robin Hood (not the app, the fictional pseudo-historical character) we want representing us.

gamestop-explained-short-squeeze-reddit-vs-hedge-funds

Second, the WSB/retail traders are NOT the only ones in play here with this. In fact, you can see clearly from the data that retail traders are net sellers of GME stock, not net buyers. I'd be willing to bet that the majority of the money in play on BOTH SIDES is from hedge funds and other huge institutional investors at this point. If the game was to "stick it to the man", well, congrats on sticking it to "the man" while simultaneously lending another "man" a helping hand, I guess. But ROFLcopter lulz? Maybe "YOLO" is the most appropriate thing to say.

Third, I'm not so sure this is a victimless crime, so to speak. While it is 100% true that this is a taste of their own medicine for the hedge funds in play, I wonder the following:

  1. Is there anything inherently wrong with short selling? Can you borrow something and then sell it to someone else, with the hopes of buying it back one day for less money? I don't know if that should be strictly disallowed ... there are some valid economic arguments to be made that it should maybe be allowed.
  2. Does it matter if the hedge funds going down also cause other funds to be damaged, either directly (because they own a slice of the hedge fund in question) or indirectly (because of butterfly effects we don't immediately see, but which might be made evident later)?
  3. Does it matter that something like $100 billion is now in play with this game, whereas even the largest short squeezes in the past have involved (for the most part) far smaller sums?

I'm not claiming to have all of these answers, but instead to point out that there may be things we haven't considered as far as "the good guys" vs "the bad guys." This isn't the ultra-simple black and white base many are making it out to be, or at least I question whether it is, and I think pausing to think about this and taking the time to understand some of the complexities before we grab pitchforks is important.

To augment that earlier point (of this being some kind of crusade against capitalism by the WSB crew), and while many users no doubt helped to build the snowball of mania by buying initially based on their convictions, it's hard to believe there aren't more retail investors who are primarily interested in getting rick quickly. Ironically, many of the people who will be hurt the most when this bubble pops are the very retail investors who were conned into "fighting the good fight", and now the shares they own will be next to worthless (most bought around the median of $200 or thereabouts).

Where Next?

Here's what is potentially the most unpredictable outcome: populist anger. We've already seen plenty of outrage from all political angles about this, which is certainly rare in modern American political memory. Opportunistic politicians have already expressed their unanimous outrage over the Wall Street bullies "forcing" apps to stop allowing users to buy the stock.

Is that really what happened, though, or is there another reason Robinhood may have wanted to slow down the process, like the not-so-far-fetched possibility that they might be sued by retail users who lose thousands on this trade? Right now, the majority of people looking in sees this as "us vs the 1%," and it's very clearly not that. This is big money on one side and big money on the other side; let's not pretend it's anything but that at this point.

Perception has a way of becoming reality, and an amplified battle against the ultra-rich may well be ahead for us in the near future. Perhaps the SEC will impose regulations that will keep hedge funds from manipulating stock prices and protect the rights of users to trade, or maybe the hedge funds will exert political leverage and keep any meaningful legislation from passing. Either way, we are in for a more introspective look under Wall Street's seamy underbelly.

This content reflects the personal opinions of the author. It is accurate and true to the best of the author’s knowledge and should not be substituted for impartial fact or advice in legal, political, or personal matters.

© 2021 Andrew Smith

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