- GameStop stocks skyrocketed over the past few months.
- Reddit users beat Wall Street Hedge Funds in their game.
- Short sellers suffer massive losses.
Most market experts were left scratching their heads when shares of GameStop an electronic retailer that has struggled over the past years and is shutting stores - skyrocketed by nearly 2,000% since the beginning of the year. The rise in share price came as a surprise as the company has struggled to make profits in the recent years. The GameStop share was trading at $350 on Wednesday, compared to less than $18 a share earlier this month. A tweet from Tesla and SpaceX CEO Elon Musk on Tuesday also boosted the stock price.
How did all this happen in such short span? Well, a group of users came together on the online forum Reddit and pushed the price of the stock, beating Wall Street hedge funds, pretty much in their own game. Interestingly, GameStop is not the only stock to have benefited from this phenomenon, several other small groups like such as Nokia, BlackBerry and AMC have also soared in the past few days.
What happed with GameStop stocks?
GameStop is one of the many companies that have suffered because of a common market practice called 'short selling'. The act involves professional investors borrowing shares of stock to sell and then buy back so that they can be returned later if the stock price goes down. In simple words, these investors bet on the failure of the company and make money on that. GameStop was one of the most shorted public company.
Now, if you are wondering how one can make money when the company is failing, the secret lies in what the market enthusiasts call 'Short Squeeze'.
What is Short Squeeze and role of Hedge Funds?
The basic market principle says buy low, sell high i.e. investors are advised to pick shares when the price is low and sell them at higher rates to earn the balance as profit. This applies for both day and long-term trading. Short sellers do exactly the opposite of that. They borrow a stock when the price is high and bet that it will fall in the coming days. If the prices go up, these short sellers are forced to buy more stocks and minimize their losses.
Usually, these short sellers are hedge funds that essentially bet against the success of a company. It's a risky position but has helped hedge funds gain massive returns over the years. The way this entire system works any positive news about the company or influx of money can increase the price of stocks, weakening the position of short sellers.
How Reddit users beat Hedge Funds?
A group of users came together on Reddit and used threads including wallstreetbets to share their ideas and create buzz around GameStop stocks. The community grew to nearly 3 million users. They started pushing the price of the stocks and benefited from trading apps such as Robin Hood that do not depend on hedge funds or money managers. As the price started going up, it caught the attention of market experts which further helped the group.
For example, the share price went up by more than 100% on the day itself when Elon Musk mentioned the stock on his Twitter handle.
The result? Hedge Funds were left with no other option but to borrow more shares to cut their losses. As the prices continued to go up, most of them ended up suffering massive loses. Melvin Capital, a $13 billion fund, had bet against GameStop by short selling its shares. However, it announced huge loses on Wednesday after injecting around $3 billion to keep it afloat.
S3 Partners, a financial data company, said Wednesday that its analysis found that short sellers had lost $23.6 billion on GameStop this month. On the other hand, users on Reddit have claimed to make big profits, having bought GameStop shares for less than $20.
What could be the impact?
This act of internet users coming together to show power over financial markets has also led to a debate around the ethics and legality of the trade. This is a unique incident and is likely to have long-term impact on market and the way it operates. It will also create some headache for the trading apps such as Robinhood that were used by the investors.
The platform has already been hit by a lawsuit, hours after it announced that users will not be able to trade in handful of stocks, including GameStop, Nokia, Blackberry, AMC, and American Airlines, due to "recent volatility." The company also said it would raise margin requirements for some securities.
The ban led to a decline in the prices of most stocks on Thursday. The GameStop stocks were down by nearly 60 per cent while others were also on a decline. The situation is so serious that even White House and financial regulators are also monitoring it.
The short squeeze has a history of returning the prices where they were before and something similar should be expected in the case of GameStop. However, the period can last longer if the players have enough resources to risk.