GameStop, Short Selling, and the Power of Reddit
GameStop is a video game retailer that has been struggling for many years with a declining business model that was worsened by the COVID-19 pandemic. Expecting its share price to fall, Melvin Capital, a multi-billion-dollar hedge fund, sold large amounts of GameStop shares short.
Briefly, a short seller borrows shares whose price is expected to fall and sells them at market prices. The short seller must later buy the shares back at market prices and return them to their owner. If the stock price drops as expected, the short seller profits from the difference between the selling price and the buying price. If the stock price rises, the short seller loses money.
A group of amateur investors rallied on an investment page on Reddit urging others to rescue GameStop by buying the shares that were sold short by the hedge fund driving up the share price rapidly.
At this stage, the hedge funds who had sold borrowed GameStop shares, had to buy back millions of shares at a higher price, pushing prices astronomically higher.
The financial marketplace is accustomed to battles by investors who have conflicting views about the value of a company. But mainstream retail investors bringing sophisticated institutional investors to their knees is unprecedented.
The Plunge of GameStop Shares
The GameStop roller coaster wiped out wealth almost as fast as it created it. Within days, GameStop stock prices dropped 81% from a peak of $483, eliminating $27 billion in market value (see chart below). Yet many small investors caught up in the frenzy the week before still think prices will improve. Others wrote off their personal losses as collateral damage in the fight against traditional Wall Street powers.
Amid the frenzy, trading platforms like Robinhood had to suspend trading in GameStop shares. Retail investors claimed the decision was due to pressure from the hedge funds shorting the stock. In a TV interview, Robinhood CEO refuted this “conspiracy theory” saying:
Our decision to temporarily restrict customers from buying certain securities had nothing to do with a market maker or a market participant or anyone like that putting pressure on us or asking us to do that. It was entirely about market dynamics and clearing house deposit requirements as per regulations.
Webull, another commission-free stock trading platform competing directly with Robinhood, also suspended buy orders briefly for GameStop, AMC and Koss shares, ascribing their decision to clearing house regulations.
The Democratization of Trading
Retail and small investors can now trade in shares easily using zero-commission applications and free online access to company information. This allows financially savvy small investors to trade for themselves, and novice investors to make risky bets that they do not understand.
Anyone can give “trading and investment tips” on social media platforms, causing random losses and gains to those who heed the advice. Similarly, social media influencers can sway retail investors to buy or sell shares with little understanding of either the market dynamics or the companies involved.
The GameStop debacle shows how digitization has changed the rules of the game, allowing retail investors to use their collective power to shake multi-billion-dollar hedge funds with unforeseen investment behavior dynamics. Is GameStop a one-time phenomenon, or an omen of shifting investor behavior? Time will tell.