What do online discussion board Reddit and Wall Street have in common? At the moment, GameStop. The video game retailer was catapulted into the public eye last week following a series of events that left many scratching their heads.
So what happened?
Entering 2021, stock of GameStop, the video game store you see in malls, was one of the most shorted of all publicly traded companies, meaning that investors were betting on the price of the stock to drop. Then, in mid-January, a group of members on the online discussion platform Reddit banded together to buy shares and drive up the price.
As more and more Reddit users bought stock, the price of GameStop shares soared, creating an ever-growing liability for short sellers. This frenzy of individual investors buying the stock forced the short-seller hedge funds to buy back shares of the stock they had sold short at even higher prices to limit their losses.
The frenzy drove GameStop stock prices up more than 400% in a week and up more than 1,700% since the start of the year.
Didn’t take stock market 101? Short selling explained.
Short selling isn’t new—but it’s not exactly common.
“Short selling is a normal part of how our markets work,” explained Steve Wyett, chief investment strategist for BOK Financial®. “It allows market participants to profit from declines in the value of a security. Because companies have a finite number of shares outstanding, an investor wanting to profit from a decline in stock price has to borrow shares of that stock to sell to other investors.”
Most investors follow the “buy low, sell high” format, but short sellers do the opposite—they borrow and sell a stock when it’s high and bet that it will continue to fall, according to NBC News. If the price doesn’t fall, however, a short seller may be forced to buy back shares to minimize potential future losses.
“An owner of a stock can request the shares of the companies they own and have lent to short sellers at any time. If enough people do that, there aren’t enough shares available for short sellers to borrow. Then they have to buy to cover and that’s where the squeeze comes in,” said Wyett.
Wyett explains it this way: Imagine you have a friend who sells baseball cards. You research the baseball card market and think certain cards are going to go down in value. So, you borrow a few cards from your friend, promising to pay them back later. You sell the cards for their current market value.
For a time, the value does fall and your prediction was right. Then, you buy back the cards for less than you paid for them, return them to your friend and pocket the profit you made. That’s shorting.
But imagine there were many baseball card traders who had the same idea, but the price didn’t drop. Rather, a group of investors rallies together to buy the baseball cards and drive up the value—far above the actual value—so you and these other “short” baseball card traders have to buy the cards you borrowed so you can return them, driving the cost up even further! That’s the squeeze. The new price may be significantly higher than you paid, so you’ll have to absorb the loss.
Wyett added that the price may go up in a way that doesn’t make any sense in relation to the value of the company. “But your losses are unlimited, so you might have to buy back to cover what you borrowed possibly at a double, triple or quadruple what you anticipated,” he said.
A game many can play
“The process of squeezing shorts has been around forever, but here’s what’s changed: the democratization of the investment process,” Wyett said. “What I mean by that is that access to information is better than it’s ever been before. Individual investors can now get a list of the most shorted stocks—that’s public information.”
In the GameStop case, individual investors gathered in Reddit chat rooms could share information and make decisions which, when combined, had a forceful impact on the market for these stocks. Wyett explained that more than 100% of the GameStop shares outstanding were sold short; that means virtually everybody was betting on the value of this company dropping.
“Combining communication platforms like Reddit with the fact that you can do it online on Robinhood or other investment apps on your phone without talking to a broker or anybody else, provides access to the markets and platforms, and makes the whole process easier,” he said. “These changes created a scenario where lots of people were able to work together and move in the same direction.”
As of this writing, the price of GameStop shares have plummeted more than 50%. Wyett said that while this was a viral phenomenon, it is unclear how it will play out and may not be the right approach to building a long-term investment process.
“Hedge fund managers have a persona of being very smart, almost arrogant, rich and not representative of smaller investors. This makes them the kind of target smaller investors can feel good about taking down,’” Wyett said. “But, I hope a large number of people know to walk out of the casino a winner. The number of people who walk out a winner is lower than the number of people who were up at some point. If you stay in too long, you’re going to give it back.”
But, he added, with new generations come new ways of doing things.
“This is not to say their approach is invalid,” Wyett said. “But it’s dangerous to count on this as a repeatable pattern. Our word of caution would be to be careful of extrapolating the success of this type of strategy into the future.”
The content in this article is for informational and educational purposes only and does not constitute legal, tax or investment advice. Always consult with a qualified financial professional, accountant or lawyer for legal, tax and investment advice. Neither BOK Financial Corporation nor its affiliates offer legal advice.