GameStop is a US video game and consumer electronics retailer which operates 5000+ stores across the world. Over the past 5 years the company has steady declined as digital downloads of games overtook the purchasing of physical video games as well as the general move to more internet retailing.
As a result, the company suffered declining revenues and profits, exacerbated more recently by the closure of stores due to the Covid-19 pandemic.
As the fortunes of the company declined, some hedge funds took notice and spotted what was to them easy money: bet on further declines in the company and therefore the stock price. Throughout late 2020 they began building short positions in GameStop stock (GME).
Enter Player 1: The Hedge Funds
How did hedge funds bet on the decline of GME? The hedge funds borrowed stock (from a bank or broker) then immediately sold this stock. At some point in the future they will be required to return the stock to the lender at which point they simply buy it back, at the now hopefully lower price, and pocket the profit.
- They borrow the stock at $50.
- They then sell it immediately for $50.
- Sometime later, when they are due to return the stock, they buy it in the market for $20 and make $30 profit.
This is called “shorting” and the hedge funds were so sure that GameStop was a lost cause that it quickly became the most shorted stock in the market, in fact so much so that more stock was shorted than the entire GameStop share capital.
Enter Player 2: The Redditors
The other player in this game are The Redditors, an internet community that hangs out on Reddit, an online news and discussion forum. One corner of this site, the Wall Street Bets (WSB) forum, has become a noisy outpost for individual investors disgruntled with the way the closed world of Wall Street makes its vast profits at the expense of people like them. It is filled with members posting trading memes and screenshots of their personal trading accounts, often showing large profits or losses – both are seen as a rite of passage.
Towards the end of August 2020 WSB started to take a keen interest in GME. There was talk of a turnaround in the company and this was exacerbated with the news of ex Chewy Inc (an online pet food retailer) CEO Ryan Cohen buying up about 13% of GME. This news, coupled with the WSB dislike for Wall Street (who were now becoming more vocal in expressing how GameStop was a dying business in a dying business sector) resulted in GME becoming a “cult” stock within WSB.
As Wall Street built up huge short positions, individual investors, using mobile apps such as Robinhood, started buying GME stock. In addition, other WSB members, after seeing the huge option profits made during the March 2020 crash, started buying GME call options. Buying options enabled even those with little cash to spare to join the game and also make much larger gains than simply owning the stock.
The game had started: Wall Street vs Main Street.
Let Play Begin: The Short Squeeze and Gamma Trap
During January, the frenzy on WSB increased: members started frantically buying GME stock and GME call options whilst posting more memes and encouragement.
The market makers selling the call options needed to hedge their exposure so bought some GME stock, this is called “delta hedging”. As the stock price increased, the position needed to be re-hedged by buying yet more stock. This is called the “Gamma Trap”.
The hedge funds, with their large short positions, have to pay a fee as well as provide collateral to the lender, in order to borrow stock. As the stock price increased the fees increased and their collateral requirements increased. Some lenders may even ask for their stock back, in which case they would need to buy it from the market, thereby pushing the price up further. This is called the “Short Squeeze”.
As you may have noticed there are multiple feedback loops: As the stock price went up this forced the hedge funds and options market makers to buy more stock, which caused the price to go up even more, which caused them to buy more stock and so on.
The WSB crowd, at the same time, bought more stock and call options. They encouraged each other to hold and not sell up, no matter what happened to the price. Reports of others making huge profits, in the form of screenshots of their stock accounts showing large profits, flooded the forum. This lead to more of them wanting a piece of the action and more buying of stock and calls.
The result of this can be seen in the chart above: the stock price (and volume) erupted during January, rocketing from $17 at the start of the year to over $350 just 3 weeks later.
So, what happens now? As I write, GME was up 134% yesterday and is already up 6.5% in the pre-market this morning:
WSB is claiming victory over the hedge funds and Wall Street.
Melvin Capital Management is the first victim; a $12b hedge fund that is down 30% this year and was rescued this week with a $2.75b capital injection from other Wall Street players.
The SEC said it was “aware of and actively monitoring the ongoing market volatility in the options and equities markets” and the new Biden administration is “monitoring the situation”.
Will this lead to fundamental market reforms or are we entering a new age of financial power shifting from Wall Street to Main Street?
(PS: whilst writing this article GME has already rose another 20% in the pre-market…).
All data and the chart shown is provided by Excel Price Feed Add-in market data formulas (Yahoo Finance data).