By now you may have noticed that GameStop, the store that you used to buy games from in the beforetimes, is having a bit of a Moment. Since the start of the year the stock price has soared to simply astronomical levels before crashing back down and causing a minor financial crisis in the process. There are not one but two Hollywood films in production already and the story isn't even over, though the ending has been all but written. For those of us whose experience of the stock market begins and ends at buying turnips on a Sunday morning, here's what's going on with the GameStop stock rollercoaster.
Ancient history
To begin to understand what happened over the past week with GameStop (and a number of other memeworthy stocks) we need to get in a time machine and return to the ancient past of summer 2020. Animal Crossing fatigue was setting in, there was a pandemic on (as you might have heard) and GameStop – a business that makes most of its money from selling physical copies of games in one of 5,000 brick-and-mortar retail locations around the US – was not coping very well.
For a few years now GameStop has been on a slow and steady decline thanks to increasing digital sales of games and online competition, resulting in an 85% loss in stock price since 2016. Though the store has a website, it is decidedly not the best in its class and all signs pointed to this spelling bad news for the company. Plus the general overheads caused by maintaining a massive physical presence in stores across the country during a deadly pandemic.
So, some investment firms that make their money from finding failing businesses that are overvalued began betting against GameStop in the stock market. This is called short-selling, or shorting, and if you haven't seen one of the 300 explainers of what that is last week (or the excellent film The Big Short) then we'll go over it in a second. But there were also investors who did not think GameStop was overvalued and actually saw potential in it.
The long run
One of these investors was Ryan Cohen, a billionaire who made his fortune selling off the very successful pet supply website Chewy.com. Cohen saw GameStop's stock price in August 2020 (hovering around the $4 mark) and thought that was absurdly low. He bought 9.98% of the company's available stocks and told the entire world about it in a thesis outlining why he thought the company was in good standing. Then, a couple of months later in November, he published a letter to the GameStop board of directors telling them to fix up their act and start thinking like a digital-first retailer. Around the same time a number of things happened one after the other that would put GameStop on the path to making that a reality and shoring up their ailing business.
Ryan Cohen (top left) and his co-investor Tylee.
(Alamy Stock Photo)
One was the new console generation launch, always a good time to be in the business of selling high-priced gaming hardware. Two, Microsoft agreed to give GameStop a cut of digital game sales on those next-gen consoles. Three, Cohen bought even more stakes in GameStop, taking him above 10% of the available common stock. This is an important threshold for other investors, because once a single entity owns more than a 10% stake in a company's stocks they can't suddenly shed those all at once if they don't like the stock anymore. They would need to notify the markets along with an explanation of why they are selling. In other words, Cohen was in it for the long run.
As if to seal that deal, GameStop then announced the appointment of Cohen and a couple of his former Chewy.com pals to their board of directors a week into January. All of these moves are very positive markers for GameStop transitioning to a strong online or digital competitor, and all with an existing name and grip on the gaming market, and a good amount of cash in the tank from a recent console launch. So, how's that short bet working out?
The shorts
All of these events slowly began driving GameStop's stock prices higher. If you check out a graph of the $GME price history over 6 months, you can actually see some of these landmarks as blips upward as investor confidence is restored. The rally begins in August from $4 when word gets out that Cohen has bought millions of shares. Then on October 15, the day Microsoft says they'll share digital sales with the company, the price jumps another $2. Cohen's November letter to the board jumps it up another dollar. By the time he is appointed to the board in January the stock is up to $20.
This is all very bad news if you've made a bet that the stock price will go down, like some hedge funds and institutional investors like Melvin Capital decided to do. The short story of short-selling is that if you think a company is about to go under, you ask to borrow some shares off someone who owns them, immediately sell those shares at the current price, then at the later date when you said you'd give the shares back you buy new ones and return them. If you did it right, the shares now cost you less than you sold them for earlier and you get to pocket the difference. If you did it wrong, you lose an incredible amount of money and the internet makes memes about you for a solid week.
The regular people are the apes and the hedge fund people are the snakes in the analogy pic.twitter.com/Fpcu18Myl9
— SteveyJ (@ImSteveyJ) January 27, 2021
Short-selling can get a bad rap as vulture capitalism, as the very act of taking out a short position against an already ailing company can undermine investor confidence and cause the stock price to go down. But it also funds a lot of financial investigation into shady companies that are trying to hoodwink or defraud their investors. As with most cogs in the capitalist machine, it sometimes gets used to make money over morals. Which is what one subreddit decided was the case with the great GameStop short.
The Merry Men
WallStreetBets (WSB) is a chaotic place. It's a subreddit for day traders that contains at least twice as many memes as it does sound investment advice. On one of the rare instances that someone was doing their due diligence, one redditor discovered that the number of short positions taken out against GameStop was actually more than there were shares available to complete the short sell. This is called Naked Shorting and is a weird quirk of the stock market that probably isn't legal but we're not the SEC so we can't say for sure. All you need to know is that hedge funds and institutional investors were making their shorts without the brokers they arranged them through ensuring that the shares being shorted were available to be "loaned out".
The day traders and retail investors of WSB decided they might be able to force this situation into an advantage for themselves by buying up whatever shares were available. This meant that if Melvin Capital, or any other Wall Street hedge fund that had short positions against GameStop, did want to close their positions (by buying shares back) then they would have an even smaller available pool to buy from. They might even be forced to buy them from WSB traders, who obviously weren't going to let them go for cheap. So a significant number of redditors (and others along for the ride) placed call options on GameStop stocks through no-fee trading platforms like Robinhood.
Call options aren't quite the same as buying a stock outright. Putting it in terms appropriate for GameStop, a call option is like placing a pre-order on a stock, paying a small down payment and reserving the right to buy a share at its current price in the future. These offer a huge amount of leverage to people without the capital to go out and buy millions of shares, because it essentially removes those shares from the available pool without the full price being paid for them. That's when the squeeze begins.
The squeeze
The opportunity WSB redditors spotted with these short sellers is that if there aren't enough stocks to go around when the short positions need to be closed, then the price will go up as a function of supply and demand. If the price goes up then the short sellers will suffer massive losses, and in order to avoid having to eat those losses they will try to close their short positions early by buying stock back. You can see how this becomes an endless feedback loop on itself. This is called a short squeeze.
The squeeze worked, with Melvin Capital calling it quits on the first day of a truly incredible rally that saw $GME rocket from $76 to almost $150. Spokespeople for the hedge fund claimed they closed out on January 26 with an undisclosed loss on their short position, though by the end of the month their entire portfolio was down 53% which is about as bad as it gets when your entire purpose is to make number go up. But by this point the story was everywhere and people wanted a seat on the rocket ship. Thousands of amateur speculators jumped onto the $GME bandwagon believing it was heading for the moon, and eventually the squeeze wasn't just on the short sellers.
Brokerage platforms like Robinhood that offer call options as a way of entering the stock market still need to actually go and buy those stocks themselves. At the point where $GME was becoming the most traded stock in the entire world, the price per share was nearing $300. Traders who place their pre-order on that stock aren't obligated to actually pay that price for their shares if they end up going down after the option is placed. But Robinhood does.
The wobble
Essentially these newbie investors were playing with the broker's funds, which is called trading on margin. Given the amount of cash platforms and their partnered brokerages like Robinhood and eToro were having to sink into excessively priced stocks in order to cover their call options, eventually things are going to look a bit dicey. That's what happened last week when Robinhood and other platforms paused trading on a number of stocks that had achieved "meme status" such as $GME, $AMC (the cinemas), $NOK (Nokia, the ancient phone company) and $BB (BlackBerry, the other ancient phone company).
The pauses were enforced in order for these platforms' clearing houses to raise enough collateral to actually acquire stocks they'd sold options for. For three days in January, $GME was trading close to 200 million stocks a day at prices well in excess of $100. However the actions to halt free trading among retail investors sparked regulatory concerns from everyone from Elon Musk to Democratic congresswoman Alexandria Ocasio-Cortez.
This is unacceptable.
— Alexandria Ocasio-Cortez (@AOC) January 28, 2021
We now need to know more about @RobinhoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit.
As a member of the Financial Services Cmte, I’d support a hearing if necessary. https://t.co/4Qyrolgzyt
The pause on retail investors through apps like Robinhood gave institutional investors and hedge funds (who do their business through slightly more robust brokerages) free rein of the market. With little competition for purchasing stocks the price of $GME crashed before retail investors were allowed back to the trough. It spiked again shortly after before continuing its decline back to the slightly more sane price of $90 where it has come to rest for now.
The fallout
Right, well, that's all a very chaotic story of how memes and dreams collide, but what does it mean for GameStop? For the retail investors? For the hedge funds? For the future of the stock market itself? Undoubtedly (and if you take a browse through WSB now you'll see plenty of stories about it) there are a number of people who got swept into the madness of the moment and dropped thousands of dollars they don't have on a lead balloon they thought was a rocket ship.
Equally there were some who jumped on board early and made a quick buck to pay off their medical bills. But in the end the biggest winners here weren't WSB redditors, or their king who has the world's most unshakeable hands made of diamond and hasn't sold a single share yet despite his potential windfall crashing from $47 million to just $22 million in a week. No the biggest winners are on Wall Street. Again. The house always wins, baby.
In the perceived battle of scrappy young underdogs on Reddit versus the institutional investors in their glass palaces downtown, the whole skirmish has resulted in billions of dollars added to the bottom line of early investors in GameStop. Cohen, of course, has made bank with an extra $4 million per hour beaming into his pocket since the start of the year. A 76-year-old founder of a subprime auto lender saw his 5% stake increase from $12 million to $500 million last week. And investment firm BlackRock has netted another $2.5 billion for its portfolio report after its 13% stake in the company, worth $173.6 million in December, turned into $2.6 billion last month.
For GameStop itself, as a business that sells games, this hasn't resulted in much of a win. For some of the executives it's been great! Four members of the board of directors have made $20 million selling stock this year. But for the company, nothing material has been gained. Executives made the smart decision not to release more stock during the frenzy as it is unclear if the SEC would look kindly upon a company with no significant changes to its operation selling off new stock at a 1500% markup. There was some discussion among financial pundits of whether it would violate a company's obligation to protect the interests of their investors by selling them stock they knew was overpriced. So in the end, no additional capital was actually injected into the operation.
And for the stock market, there are a number of political figures calling for tighter regulation of trading. This, along with multiple lawsuits filed against trading platforms like Robinhood, will likely result in a chilling effect on firms that retail investors might use while institutional investors continue to use the system the same way they always have. Or, in the event no further regulation is enforced, the stock market will become increasingly volatile at the hands of decentralized communities intent on causing mischief with the potential for a quick win. It's hard to see many upsides to the chaos that just happened, to be quite honest.
Anyway, if this was too long to read then you can just wait for the Netflix movie that might be coming from the guy who wrote The Hurt Locker, or you could watch The Big Short again.
