“May you live in interesting times”
The world of Wall Street and the stock market is paradoxically exciting and mundane—often volatile, yet predictable in its volatility. This is the typical state of things. This past week, however, was anything but typical. While many celebrate what could be described as one of the greatest transfers of wealth in recent memory, some are resistant to a precedent they hope remains anomalous.
GameStop is a video game and consumer electronics retailer that by most accounts had poor future prospects. Its largely brick-and-mortar business model, which included the buying and selling of pre-owned, physical games, was unable to compete with the digital gaming infrastructure developed by companies like Microsoft and Sony. This was reflected by its dwindling revenue and stock price. In fact, GameStop’s demise was so assured that financial bets against the company reached levels matched by none. Most of these bets were made by short selling GameStop stock (say that three times fast)—short or shorting being terms you’ve likely heard many times in the midst of this news cycle dominating event.
The type of stock market investing you’re likely most familiar with is what’s called a long position, which is a bet that the price of a security or derivative will increase in value. Typically that means simply buying a stock with the expectation that the price will go up so it can be later sold at a higher price. A short position, on the other hand, is a bet that the price will go down. Think long/up and short/down. Short selling—the most common type of short position—is a risky investment strategy that involves borrowing shares of a company from a broker and then immediately selling them at their current market value so the shares can then be repurchased later at a (hopefully) reduced price. The shares are then returned to the broker and the investor pockets the difference.
It goes something like this:
There are whispers that Jeff Bezos is taking the name of his company seriously and plans to move Amazon’s headquarters to the literal Amazon rainforest. Amazing as it would be to have an office in the lush jungle—workspaces sporadically resonating with echos of a distant howler monkey—perhaps it’s not the best locale for overseeing corporate operations. Amazon stock is currently trading at $2 per share, but if the rumors are revealed true, you think the price will take a hit. You go to your broker, borrow 100 shares, and sell them. You now have $200. A month later, Bezos remotely broadcasts an announcement as poison dart frogs blip in and out of frame, confirming the rumors. With seemingly no justification for this erratic move, the stock price tanks expectedly. The price per share has gone all the way down to $1. You purchase the 100 shares you owe your broker, now valued at $100 in total, and return them. The $200 from the initial sale minus the $100 you just spent to repurchase the borrowed stock is your profit of $100.
It’s important to note that borrowing isn’t free. You incur a fee each day you haven’t returned the borrowed stock. For the sake of simplicity I omitted that from my example but keep it in mind later on. You can hold your short position for a long time, but it’s going to cost you.
R/WALLSTREETBETS and U/DEEPFUCKINGVALUE enter stage right
Reddit.com is a popular discussion and content aggregation site comprised of thousands of sub-communities called subreddits, where users post and discuss subject matter relevant to whatever subreddit they’re on. The subreddit r/news, for example, is about the news, r/science is about science, and r/JohnCena is about potato salad. One such subreddit is the investment oriented r/wallstreetbets (WSB for short). They say they’re “Like 4chan found a bloomberg terminal,” but for those not just hit with a surprisingly illustrative picture, the community—simultaneously brash and self-deprecating—loudly discuss typically risky investment opportunities. U/DeepFuckingValue is a member of this community who started posting about his long positions in GameStop as far back as a year and a half. He posted regular monthly updates of his turbulent results—something WSB is all too familiar with—and he was met with arguably justified, smug detractors, insisting he was throwing away his money on a floundering business going the way of Blockbuster. Then in August of 2020, his head-scratching bet was making, if not yet sense, certainly money. Now posting more frequent updates, he seemed no longer on a roller coaster but a starship. His most recent “month-end update” for January, 2021, showed an over 4,000% gain in his investment, netting just over $31 million for a total of $46 million.
U/DeepFuckingValue was maybe surprisingly not the only person who saw potential in the struggling retailer. Michael Burry—who famously and successfully shorted the subprime mortgage market that collapsed and triggered a global financial crisis in 2008—ironically found himself on the other end of the bet, this time taking a long position in GameStop in the middle of the COVID-19 pandemic. And in the months leading up to where we are now, the users of WSB started to pile in as well.
As mentioned previously, GameStop’s continued decline made it the most heavily shorted company worldwide (and it still is). Short interest—an indicator of market sentiment—was as high as 140%. Short interest is typically shown as a percentage derived by dividing the amount of shares short and not yet repurchased, by the number of available traded shares. Think about that for a moment. How could the number of shares short be higher than the number of available shares? How could short interest be more than 100%? Well, Wall Street—never one to shy away from irresponsibly creative financial instruments—can do this with naked shorting, which is when shorted shares are sold that may not actually exist. The practice is illegal but still possible through loopholes, and lending shares that have already been sold short is a way to achieve this. Shares are borrowed, sold short, and then those same shares are lended again.
It’s this extreme short selling and the general disdain for institutional short sellers (professional traders, e.g., hedge funds)—accused of manipulating markets and hurting companies for their own gain—mixed with the increasing collective power of the retail investor (non-professional, everyday people) that catalyzed what may represent a paradigm shift in securities markets. Buying and holding GameStop stock became about more than just making money—it was a statement.
While short positions can theoretically be kept open indefinitely, a rising stock price may make closing at a loss necessary to protect against additional losses. The lender can also request the return of the borrowed stock or close the position themselves. If the price of GameStop stock remains high, short sellers will have no choice but to close their positions, which requires the repurchasing of the borrowed stock. The effect of this repurchasing on the market is no different than when investors enter long positions, and it puts the same upward pressure on price. When short positions are closed within the same general time period, the price can get very high, very quickly. This phenomenon is called a short squeeze and it’s what WSB and any long GameStop investor hoped would happen.
With their high-octane, meme-fueled bravado, WSB cultivated a gravity well of hype around GameStop, attracting all who crossed their path. And the resulting stock price increase only compounded this momentum. GameStop stock is up 235% over the last trading week alone. Zooming out to the six month chart shows an absolutely ridiculous 8,000% increase. As anticipated, short sellers were getting crushed. Melvin Capital, a hedge fund with $12.5 billion in assets under management, took one of the hardest hits, requiring a $2.75 billion lifeline from hedge funds Citadel and Point27. Short sellers have lost an estimated $19 billion on GameStop year-to-date. Melvin Capital manager Gabe Plotkin said the firm closed out its short position but according to Ihor Dusaniwsky, managing director at S3 Partners, most short sellers have not yet covered, and many who have were replaced by new shorts. “In actuality the data shows that total net shares shorted hasn’t moved all that much,” says Dusaniwsky.
Some have called attention to the dangers of a stock price that is wildly detached from any fundamental evaluation. Massachusetts Secretary of State William Galvin said on CNBC that the issue is “about the honesty of the marketplace, reliability of the marketplace, and the danger a defective and dishonest marketplace has to our economy.” He went on to say, “there is no reality to these trades and these issues that we’ve been speaking of. They’re not based on anything other than speculation.” Many, however, are pushing back against this sentiment. In the same segment, businessman and Shark Tank co-host Kevin O’Leary said,
The definition of the market is speculation. When you buy and stay long a stock you’re speculating the profits you hope are going to come finally appear, and you take that risk. The best thing we can do for this market now is leave it alone and just shine the light of transparency on it. If you are short let it be transparent. You now run a new risk that these effective social-media vigilantes are gonna come after you and squeeze you as a short. That’s gonna make a lot of hedge funds think a second time before they try and go short stocks, which I think is great.
In another CNBC interview, investor Chamath Palihapitiya said, “I think that what you’re seeing is essentially a pushback against the establishment in a really important way.”
Other statements appeared to confirm the disconnect of Wall Street and Main Street. Former SEC Commissioner Laura Unger compared the GameStop short squeeze to the January 6th Capitol riots saying, “If you don’t have the police in there at the right time, things go a little crazy.” She clarified that the financial phenomenon is of a lesser degree, but the analogy still fell flat. Perhaps the most out-of-touch perspective came from hedge fund billionaire Leon Cooperman who said, “The reason the market is doing what it’s doing is people are sitting at home getting their checks from the government… okay, and this fair share is a bullshit concept. It’s just a way of attacking wealthy people and, you know, I think it’s inappropriate. We all gotta work together and pull together.”
Now it would be disingenuous to say that the idea of profiting from a GameStop short squeeze began as a high-minded effort from retail investors to beat the billionaire class purely on principle. From the start, the possibility of a short squeeze was motivation for the buy-and-hold strategy and it was unambiguously about making money—no question about it. But somewhere along the way it became something more. It was a real life Robin Hood story. Which reminds me…
A major factor in the newfound stock market accessibility for the retail investor is the investing app Robinhood. Its slick interface and zero-commission trading made it the preferred choice for those who had maybe a few hundred bucks to throw at the market. And it undoubtedly enabled the rise of GameStop stock. But in defiance of the very user base responsible for its success, Robinhood suspended the buying of GameStop and other heavily shorted stocks that had similar attention from WSB and retail investors. Selling, however, was still allowed. As you could imagine, restricting buying but allowing selling can only do one thing: put a downward pressure on price. Of course Robinhood is not the only brokerage but because so many retail traders relied on it, the impact—though difficult if not impossible to quantify—was certainly felt. Other brokerages like TD Ameritrade and Charles Schwab also restricted trading, though not to the same degree as Robinhood (buying stock was still possible), and Nasdaq CEO Adena Friedman warned that the exchange would halt trading if it matched social media chatter to unusual activity with a stock.
This prompted immediate backlash from Robinhood users and prominent figures alike. Congresswoman Alexandria Ocasio-Cortez tweeted,
This is unacceptable.
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.
To further illustrate Wall Street hypocrisy, Washington Correspondent at The Hill Saagar Enjeti also tweeted,
NASDAQ lets Hedge Funds run wild all day and Wall Streeters plot/pump up their views 24/7 on CNBC & investor conferences. But at the hint of being beat at their own game Robinhood and Discord pull rug from redditors in 24 hours
And in a humorous flip of the script, Twitter user Jean-Paul Blarte: Mall Cop wrote,
If I was a Hedge Fund losing billions to Reddit shitposters, I would get a second job driving for Uber, cut out the Starbuck’s, and skip the avocado toast.
Robinhood defended the move saying,
As a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearinghouse deposits. Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment. These requirements exist to protect investors and the markets and we take our responsibilities to comply with them seriously, including through the measures we have taken today.
But many find this explanation unconvincing and believe Robinhood may have been pressured by affiliated hedge funds to stymie the short squeeze that had already cost them billions. Speculation abounds.
Retail investors who once traded at the whims of their Wall Street overlords have displayed a burgeoning influence in spectacular fashion. Short selling is not an inherently immoral practice and it can be a tool to correct a bubbling stock valuation. But the practice of reckless short selling at the expense of struggling businesses and healthy markets may happen less now that a novel countermeasure has put shorts in check. And maybe the middle and working class can make some money along the way.