GameStop, short-sellers, Reddit rebels and Wall Street’s wonky plumbing

You have to hand it to them. They had a good go at giving the suits a run for their money. But now it seems that the army of ordinary speculators (more than eight million at last count) who banded together on social-media site Reddit under the “r/wallstreetbets” bulletin board, has been defeated. “Buy and HODL” was the battle cry. But as of the time of writing, GameStop – the original battleground stock – has slid from a peak above $400 to below $100, while other target stocks have also tumbled. Meanwhile, in the commodities market, silver spiked on rumours that it was next, then tumbled as rapidly as it had gone up. Is the dream in ruins? Has “The Man” crushed the little guy once again, or is this about something else altogether? Let’s start by looking at what actually happened here.

Revenge of the value investors

The first thing to understand is that despite the popular narrative, this didn’t start out as a grand rebellion against “the suits”. It started out as a value investment. GameStop is a struggling video-games retailer, with around 5,500 physical branches, mostly in the US. You don’t have to be a financial analyst to see that this is a weak business model in an era in which computer games are already widely downloaded online (via platforms such as Steam). Throw in Covid-19’s impact on high-street shopping, and you have a recipe for disaster. So it’s little wonder that many people saw the stock as a classic “short” (where investors bet on the price falling rather than rising). The share price went from being around $30 a share in early 2016, to below $5 by last summer.

However, even a bad business may have some value left in it, assuming you can get hold of it at the right price. And some value investors saw GameStop as a potential turnaround play. That’s what 34-year old Keith Gill – or DeepF**kingValue, as he is known on r/wallstreetbets – reckoned as long ago as June 2019. He started investing in GameStop’s shares then, when the price was around $5. As The Wall Street Journal reports, “he saw potential for the struggling retailer to reinvigorate itself by attracting new customers with the latest video-game consoles”. Other investors, says Gill, had written off GameStop as the next Blockbuster. “It appeared many folks just weren’t digging in deeper. It was a gross misclassification of the opportunity.”

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You’ll note that Gill is neither a bored teenager, sitting on his government stimulus cheque, nor a desperate man out to get revenge on “the Street”. In fact, he was a financial adviser with a Chartered Financial Analyst qualification, who also ran a YouTube channel on finance under the name of “Roaring Kitty”. He had a sensible – if risky – thesis on GameStop, and he wasn’t the only one. Noted short-seller Michael Burry (who became famous for betting against mortgage-backed securities before the 2008 crash, thus earning a starring role in Michael Lewis’ book, The Big Short) also bought GameStop in 2019, for similar reasons. Then, in the middle of 2020, with the share price down to around $4, activist investor Ryan Cohen bought into the stock. In November he started putting pressure on the company’s management, asking for a seat on the board, to help drive through the turnaround plan (mostly getting rid of the physical branches and moving online).

So GameStop started out as a pure value investment. And it was working. By the end of 2020, all that turnaround talk had driven the price up from $4 in summer 2020 to above $20. A 400% gain in six months – not to be sniffed at. But what happened next? How did the share price go from $20 to more than $400 at one point, during the trading frenzy of January? That’s where David and Goliath come in.

Reckless short-sellers

As we’ve already noted, GameStop looked like a dud company for lots of reasons. So short-sellers had been betting heavily that the share price would fall, and as the price rose they started to bet even more heavily against it. Here’s a quick primer on how shorting works (there’s a lot more at the MoneyWeek website). If you want to short a stock, you have to borrow it first. You then sell it. You then hope that the price falls. If the price falls, then you’ll be making a profit on paper. At this point, you can close the short position by buying the shares back and returning them to the original owner. You keep the profit you made (the difference between the price at which you sold and the price at which you bought). If the price rises, however, you’ll be losing money on paper. At this point, you can hang on and hope it goes down. But if it keeps rising, eventually you’ll hit a point where you’re forced to sell because your paper losses are just too big to sustain.

There were two main drivers of the wild surge in the price of GameStop and unlike the original “value” investment neither had anything to do with the company’s fundamentals. The first was a “short squeeze”. Remember – when you short stock, you have to borrow it. The short-sellers got so excited about GameStop that they collectively borrowed more shares than were actually in issue – “short interest” reached 140% at one point. This is public information and it left the hedge funds who were short in a very exposed position. Indeed, some have argued convincingly that it was a colossal failure of risk management on their part. Why? Because if prices move higher, then many short-sellers will be forced to close their positions by buying the stock, which in turn drives prices higher, triggering more pain for the remaining short-sellers, and so on. Given the sheer volume of short interest in this case, the risk of a vicious upwards spiral should have been obvious.

However, the sheer violence of this move was due to something even more obscure – a “gamma” squeeze. To cut a long and technical story short, this is all about options activity around the company. An option gives you the right to buy (a “call” option) or sell (a “put” option) a share at a specific price, within a specific time frame. The broker who sells you this option then has to hedge their own exposure by buying or shorting the underlying shares. Put very simply, the big move in GameStop’s share price and activity around the share created a lot of forced buying by brokers who needed to buy more shares to hedge their option exposure.

Meanwhile, of course, as the price was rising, the r/wallstreetbets group were getting more and more excited and buying even more – some with the hope of profit, some for a laugh and camaraderie, most with both – and this exacerbated the whole move. As a result of the price spike, Melvin Capital Management – the most prominent hedge fund involved – lost 53% in January alone and had to raise $2.75bn in funds from fellow hedge funders Steve Cohen of Point72 and Ken Griffin of Citadel. Other losers included a hedge fund called Maplelane Capital, which lost 45%.

So much for “power to the people”

But it’s what happened next that really cemented the David versus Goliath narrative. A lot of the people betting on the stock (and other heavily shorted companies such as cinema chain AMC) were using free-to-trade brokers and apps such as Robinhood. These apps don’t charge investors anything to trade. Instead they make their money by selling the order flow to market makers, who in turn execute the trades and pocket the difference between the buying and the selling price (the “spread”). This is a controversial practice because of questions over whether or not it means small investors get their trades executed at the best price – as always, “free” doesn’t mean “free”, it just means it costs you at another point in the process...

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