Centsees, we absolutely have to talk about one of the most mind-boggling financial stories that we may experience in our lifetimes. The craziness that has unfolded in the last week is like nothing I’ve ever seen before, and before you ask, yes, I was an adult during the 2009 Great Recession. It could be a once-in-a-lifetime event with consequences for decades. Grab a healthy beverage, sit back in a comfortable chair, and stretch your “Diamond Hands” because this adventure is really that good.
It’s safe to say that no market expert knew what to expect going into 2021. The stock market is soaring but so is unemployment. The vaccine is imminent but so is the closing of many struggling businesses. Vaccinations rates are increasing but so is the threat of a new strain of the virus. Interest rates are low but so is the recovery for poorer Americans.
What no experts could have predicted, however, was the focus that would be given to one small stock and the massive political, economic, and societal implications that would subsequently come into play. Nevertheless, nearly every major news outlet like CNN, Bloomberg, The Wall Street Journal, and New York Times have united in following one saga that has captured the attention of the world.
This is the story of GameStop.
Quick Tip, Note, and Definitions
Quick Pro Tip: I’d recommend to my readers to not engage in the behavior exhibited by either side of this story. There are safer and more reliable ways to make money, and much safer and more reliable ways to protest inequity. Nothing in this article is even remotely financial advice, though always try to learn from the mistakes of others.
Note: This is one of the more complex topics we’ve covered in TheCentsei so far. If you feel lost at any point, check out the Analogy and Summary sections at the end. Also, feel free to leave your questions in the comments. I’ll get to them all.
Definitions:
••••• Buying a Stock – As someone with an interest in personal finance, you likely understand the idea behind buying a stock. A stock is a small percentage ownership in a company. Stocks are worth money if either (a) the company pays dividends to its owners or (b) the stock price goes up and you sell your stock for a higher price than you paid for it.
The maximum amount of money one can lose is whatever he/she invested in the stock, no more. The maximum amount of money one can gain is “infinite,” since there is technically no specific limit to how high a stock can go or how much it can pay out in dividends. For example, if buy a stock for $30, the most you can lose is $30 and the most you can gain is thousands or millions (very low chance, but you get the picture). People generally buy a stock if they believe the price will go up so they can sell it later at a profit.•••••
••••• Shorting A Stock – What may be less familiar to you is the idea of short selling a stock. Under a simple form this model, the investor will borrow a stock from its owner (the lender) and sell the stock on the market at the current market price. When the borrowing period is over, after, say 30 days, the borrower must then repurchase the stock at the then-market price and repay the stock to the lender.
This repurchase price may be higher or lower than what the short seller originally paid. If the new market price is lower, the short seller makes money because he/she and pocket the difference when the stock is returned to the lender. However, the short seller will lose money if the re-purchase price is higher than the amount originally paid.
The maximum amount of money one can earn as a short seller is the original market price of the stock, no more. The maximum amount of money one can lose is “infinite,” since there is technically no specific limit on how high a stock can go (and therefore how much it will cost to repurchase the stock at the specified time). For example, if you short a stock for $30, the most you can gain is $30 but the most you can lose is thousands or millions. People generally short a stock if they believe the price will go down.•••••
••••• Short Squeeze – Most factors that affect a stock’s price can be explained by underlying fundamentals, such as the company’s financial performance, positive or negative public news, or announcements about a change in strategy. A short squeeze refers to a rare phenomenon where there is a rapid increase in the price of a stock due to unexpected technical factors in the market rather than underlying fundamentals. This can occur, for example, when there is a lack of supply and an excess of demand for the stock due to short sellers covering their positions, buying back stocks.
Recall that a short is basically someone borrowing the stock and promising to buy and return it at a certain date in the future. There’s nothing fundamentally wrong with this, except the rules allow for a stock to be shorted multiple times. In other words, Person A shorts it to Person B, who shorts it to Person C, and so on. A double or even triple short, for lack of a better term. In effect, more stocks are effectively loaned out than exist for repayment. A house of cards, in a way.
When a shortage of stock exists, short sellers now knows that they will be competing against other short sellers for a low amount of stock. As demand quickly increases, so does the price. The holders of the stock also know that the short sellers are going to have to pay off their debt in the future so they may be less likely to sell, hoping for a better price as demand intensifies. Other people may also enter the buying and selling market in hopes of making a quick buck. In the end, some short sellers are not going to be able to fulfill their obligation to rebuy the stock at the specified time. Thus, they are “squeezed” into either buying the stock at a massive loss, posting collateral (cash) to cover their potential loss, or doubling down on their short sale in the hopes the price returns again (but multiplying their losses if it doesn’t). The stock price, of course, continues to soar as more and more of these short become due.
With that out of the way, on to the good stuff!
1984-2016 “The Rise Of A Retail Goliath”
If you have so much as entered a mall or outlet strip in the last 20 years, there no doubt that you would recognize the white and red logo that has become synonymous with video game sales, GameStop. GameStop was founded in 1984 as a company called “Babbage’s,” but after rebranding and acquiring toy goliath E.B. Toys in 2005, GameStop has held a near monopoly on video game retail stores for the last decade and a half. The company grew to over 5,000 retail locations, earned $400 million in net profits per year, and was listed as a Fortune 500 Company.
2016-2020 “The Fall Of An Empire”
GameStop has faced significant challenges over the last five years. The demand for physical copies of video games has been slowly replaced by digital downloads of games. Nearly all major video game developers now offer games via download and connect to consumers electronically with platforms like Xbox Live, PlayStation Network, Nintendo eShop, and Steam. Gamers can purchase games instantly from the comfort of their home, and the developers save on the manufacturing, shipping, and retail costs. Furthermore, mail retailers overall have been struggling to adapt to changing consumer purchasing behaviors, and GameStop is no exception. Finally, with the rise of the pandemic in 2020, GameStop has seen the closure of many store locations around the country.
This unholy trifecta of market conditions had a devastating effect on GameStop’s financial condition. The company went from $500 million in profits in 2016 to a $670 million loss in 2018 with equally poor results in 2019 and expected in 2020 as well.
After hitting a rise to $56.53 in November 2013, its stock (NYSE: GME) price plummeted to an all-time low of just $2.80 in on April 3rd, 2020.
2019 (Player 1) “DeepF**kingValue” from r/WallStreetBets”
They say there is a sub-reddit for everything, so if your passion is making risky stock picks and posting your results online, then r/WallStreetBets (which I’ll start calling WSB in this article) is for you. WSB started out as a forum for inexperienced investors to make a “bet” by investing considerable amounts of money in an unpopular stock and posting their results on WSB to the delight (or mockery) of others in the forum. In a lot of ways, this sub-reddit was a culmination of things that we don’t normally promote in this blog: glorifying stock-picking with an unhealthy dose of social media dopamine reinforcement.
In September 2019, one member of WSB called DeepF**kingValue or DFV (this is a family-friendly blog, folks, but fill in the blanks!) decided to invest $50,000 in GameStop as the stock price plummeted and bankruptcy was expected in its future.
DFV, however, felt that GameStop may have been undervalued, and there may have been a nugget of truth to his inclination. Investor Michael Burry had just broadcasted optimism in the stock because Sony and Microsoft had announced 2020 release dates of their next generation game consoles with physical disc offerings. DFV was unphased by negative news surrounding GameStop, and even after his $50,000 original investment, he continued to buy more and more stock throughout the past year, reporting many of his moves on Reddit. At one point, he posted a screenshot where he was down $34,000. He earned a reputation of being persistent and nickname of having “Diamond Hands.”
Notice the verbs here in past tense. We’ll get to that.
DFV is Player 1 in our story.
2019-Present (Player 2) “Melvin Capital Management” and other short-sellers from hedge funds
Recall from our definitions that people buy stocks that they think will go up in value and short stocks that they think will go down. The average investor buys and holds stocks as part of a long-term investment plan and will not generally short stocks because of the risk of losing substantial amounts of money in a short period of time.
However, large investors like hedge funds have the wealth to both buy and short stocks because they can absorb the risk.
One such investor is a company called Melvin Capital Management LP, which is based in New York City and reportedly has $20 billion in assets under management as of September 2020. Melvin Capital has engaged in a substantial amount of short selling of GameStop’s stock in the past year or two under the belief that the company is overvalued and the stock price will fall.
Melvin Capital is Player 2, along with all other hedge funds, investment firms, and banks that engage in significant amounts of shorting of GameStop’s stock.
Summer 2020 “Hope For GameStop?”
After a third of its physical stores closed their doors at the start of the pandemic, reports showed that GameStop had experienced a 519% jump in online sales, though the company was still losing significant amounts of money. A few months later, Chewy.com co-founder Ryan Cohen announced his intent to purchase 9% ownership of GameStop. Finally, the company formed a multi-year strategic partnership with Microsoft to boost its digital omni-channel ecosystem.
The company’s digital sales increased, and GameStop slowly began to see its stock price rise from a low of $2.80 per share in April 2020 to $14 in October after the announcement. Cohen increased his ownership to 13% 2013, potentially signally further optimism in the company.
Nevertheless, many of the large investors like Melvin Capital believed that the price increase was temporary and would return back down over time.
Note that nothing particularly unusual has happened… yet. GameStop’s turnaround is a nice story but hardly unprecedented. Some people believed in the stock, others didn’t. The next few months, however, is where things start to get wild.
October 2020-Present “The GameStop Short Squeeze”
Around this time, other users of WSB (the sub-reddit) noticed an unusual characteristic of GameStop’s investing characteristics. Data was beginning to show that GameStop was one of the most shorted stocks on the market, implying that huge investors like Melvin were betting against GameStop in records numbers. One source said 90% believed the stock price would go down.
In fact, at one point, 140% more GameStop stock had been shorted than existed on the market.
WSB began rapidly buying up the stock, having identified that these short sellers might struggle to repurchase the stock in the required timeframe. Given that the double and triple short positions had led to staggering amounts of the stock being shorted implied that the stock might suddenly fluctuate in price, not due to underlying fundamentals but rather due to unexpecting market conditions.
Thus, the GameStop “Short Squeeze” was born, and foreshadowed massive losses for the short sellers as rapid increases in demand and little supply meant that the price was about to spike.
January 27th 2021 “Hold The Line”
Most short squeezes are ultimately resolved when the price reaches a point where enough stockholders are willing to sell and the short sellers can clear their position.
However, WallStreetBets isn’t your typical stockholder. Through a series of coordinated Reddit posts, WSB collectively agreed that they would hold their position (i.e. not selling their GameStop shares). In some cases, users vowed to hold until the price reached at least $1,000 per share, while other vowed to hold no matter what. Some users even purchased what is known as options contracts to effectively double down on their position.
To Reddit, GameStop had become more than way to make money and post about their earnings. It had become a symbol of smaller, poorer individual investors now being in control of the market and profit massively off the larger, richer corporate investors like Melvin Capital. The Reddit users understood hedge funds’ detrimental role in the Great Recession, the K-shaped recovery of the pandemic, and political and economic problems that had affected their lives and their country. They galvanized around GameStop and saw the squeeze as as a way to collectively punish the hedge funds greed to the tune of billions of dollars for a small investment made by thousands of WSB users. David vs Goliath.
As of Wednesday January 29th, their plan had worked. GameStop had risen to $370 at one point and the WSB Reddit called for people to “hold the line” and not sell their stock so the damage to the hedge funds would multiply.
January 28th 2021 (Players 3 and 4) Goliath calls for backup: “Robinhood” and “Citadel”
Founded in 2013, Robinhood owns and operates an app that serves as a brokerage (place where people can buy stocks). Where websites like Fidelity and Vanguard have traditionally been used by older generations for years, the Robinhood app is particularly popular among small investors from younger generations, who enjoy the apps features like buying fractional shares and trading at zero-cost. Many Reddit users solely use Robinhood as their primary means of buying and selling stocks.
Robinhood routes more than half of its customers’ orders to a company called Citadel Securities, who physically executes its orders. Citadel is, by far, Robinhood’s largest partner by volume, and there is a great deal of shared success between the two companies.
On the morning of January 28th, Robinhood announced, without warning, that it was restricting its users’ ability to buy certain stocks Robinhood believed to be “high risk,” including GameStop. Robinhood customers could sell, but not buy, GameStop stock. A few other brokerages took similar measures, but Robinhood’s actions caught the market by surprise. Immediately after Robinhood’s announcement, GameStop’s stock price fell from its all-time high of $469 at 10AM Eastern to $132 at 11:30AM. The stock price had dropped 70% in less than 90 minutes.
It’s very difficult to prove cause and effect when it comes to the stock market. Did Robinhood’s action cause the stock to fall, or was it other factors? We can only speculate.
Either way, the result was that at that moment, the Reddit uses lost billions of dollars in equity, and the hedge funds mitigated billions on losses on their short sale. Investors who wanted to buy or sell the stock during that timeframe were banned from doing so. Robinhood claimed the buying restriction was for the good of its users.
It may strike you as a bit odd that Robinhood would do this. Wouldn’t they want people using their app for trades, especially a high-volume stock that interests its core users – young internet-savy small investors?
THEORY 1 (Robinhood’s claim): Clearing problem
Apps like Robinhood don’t actually record the trade and settle money immediately when you attempt to buy or sell. Rather the process goes through a transaction settlement process using a “clearing house” like APEX Clearing Corp, and the process can take 1 to 2 days. These parties basically ensure that the buyer has money and the seller has the stock, and that neither party has gone bankrupt in the time it took the transactions to clear.
When a stock is particularly volatile, a clearing house will sometimes require the brokerage (Robinhood) to pay a cash “reserve” to protect the clearing house from unfulfilled transactions. The clearing house doesn’t want to lose money if the transaction can’t be fulfilled, so it sometimes puts restrictions in place to protect itself if it can’t afford the cash reserves required to guarantee the transaction. If the brokerage can’t or won’t fund the reserve, the only other option is to stop trades entirely. Indeed, multiple brokerages other than Robinhood put restrictions on stocks like GameStop because of their clearing houses.
Robinhood has said that the reason it suspended buyers on Thursday was because of an issue like this with its clearing house. It’s clearing house required a reserve, and Robinhood couldn’t (or wouldn’t) pay up. Some investors wondered if Robinhood was facing financial troubles and couldn’t afford the reserve, but Robinhood’s CEO denied these allegations.
It’s not yet independently confirmed whether this was the case with Robinhood and its clearing house. It’s also not independently confirmed what, if any, financial problems Robinhood is facing and what implications such financial trouble would mean for its users.
THEORY 2 (Reddit’s claim): Market Manipulation
Market manipulation is the act of artificially inflating or deflating the price of a security/stock for personal gain. In most cases, market manipulation is very, VERY illegal.
Citadel had recently made a $2.5 billion investment in Melvin Capital. Yes, the same Citadel that has a deep partnership with Robinhood also has a $2.5B ownership stake in Melvin Capital, the hedge fund that could stand to lose $10-20 billion+ if GameStop stock kept going up. If, hypothetically, Citadel were to “pressure” Robinhood to stop its users from buying GameStop stock, Citadel would also be able to save Melvin from a massive loss and thus protect its billion dollar investment in Melvin.
The WSB users filed a class action lawsuit in the state of New York because of Robinhood’s actions.
In short, Citadel has a partnership with Robinhood (who restricted sales of GameStop Stock) while also having an ownership in Melvin Capital (a hedge fund who shorted GameStop stock and would benefit from such restrictions).
Some WSB users suggest that this potential conflict of interest could have led to coordinated market manipulation between the parties. Citadel/Robinhood/Melvin deny such allegations and blame Robinhood’s actions on its clearing house.
Both parties are calling for the SEC to intervene and regulate the other group.
It is up to you, the reader, to decide which of the two theories you believe. Perhaps time will tell, if evidence is gathered and whistleblowers come forward.
January 30th 2021 – Present “GameStronk”
After most of the platforms like Robinhood partially or completed removed their restrictions on Thursday or Friday, GameStop recovered some of its value on Thursday and returned to $325 by the close of trading on Friday the 30th.
Melvin has reportedly closed its short position in GameStop, though these reports rely on a Melvin spokoesperson. Many politicians and celebrities, include Alexandria Ocasio-Cortez, Ted Cruz, Elizabeth Warren, and Elon Musk, have voiced their opinions about the subject, most siding with Reddit and the people, commending their taking a stance against the injustice.
Our friend DFV, Player 1, posted that his investment this week was worth $22 million on paper, though he is going to remain “GameStronk” (strong) and hold his position.
Keep in mind, however, that none of this has anything to do with the fundamentals of GameStop as a company. Though they have seen some growth in a few areas, the company is still losing money, retains lots of debt, and will struggle to keep its stores open during the pandemic and the move to digital downloads from game developers. GameStop did not suddenly solve all these problems in the last week, and likely isn’t a good investment from a fundamental perspective. The changes in price were primarily the result of a short squeeze rather than the improved financial performance of GameStop.
Toilet Paper Analogy
Let’s make this situation easier to understand with an analogy.
Lessons Learned
Here are the lessons we can take away from this situation:
1) Don’t bet on individual stocks and don’t bet on shorting stocks as fundamental tools for financial success. Neither is much better than gambling, so if you choose to partake, be prepared to lose everything. A much better financial plan is to invest in wide-sweeping index funds with low expense ratios that meet your risk tolerance. Invest as early and often as you can and hold for the long term. If you choose to invest on specific stocks, research your investments and understand them fully, using multiple sources and verifiable financial data and focusing on the company’s outlook. Hype and speculation do affect stock prices in the short term, but they are not a reliable path to long term wealth.
2) Additional regulations in the investing space are needed, particularly short selling. As we saw with the Great Recession and again now, these investments are dangerous and prone to foul play. Short selling provides no creation of value for the economy. It is illogical that more shares can be shorted than exist in the market as a result of these double and triple shorts. It’s also unfair that a platform like Robinhood can restrict the buying decisions of its users without consequence. More clarity is needed on who reserves the right to stop buying and selling of stocks (ex. Robinhood and the clearing houses), as well as how market manipulation is defined. No conflicts of interest should exist between various parties in buying, selling, and shorting. Finally, there is a significant inequality of information between small investors (who operate based on dated information and inferior access to trading services) and large investment firms (who have the resources and technology to make faster, more well informed decisions). These problems don’t have simple solutions, but we can hope that the regulatory bodies that oversee the largest market players will learn from this experience. “Hope.”
3) It’s noble to take a stance against injustice when you sense it but do so in a way that is likely to enact change, not meme about it. We’re not even sure Reddit will be successful with any kind of reform, and I wouldn’t recommend jumping on a Reddit bandwagon to fight your battles (and really don’t recommend social media at all). Rather, you’re much better off getting involved in your community, staying active in local politics, supporting politicians who best reflect your value, and doing your best to educate your loved ones (or the general public with a blog) to avoid falling into social or financial traps. We do need to take action to correct the economic injustice that has kept so many from participating in the market, but putting up money to buy some stock won’t be as effective as those using the legal and political system to enact change.
Summary
TL;DR. GameStop had been doing poorly financially for years. As some small good news began to come out about the company, many users for Reddit’s “r/WallStreetBets” group began investing substantially amounts of money into GameStop. Large hedge funds and investment companies who had shorted GameStop’s stock stood to lose a lot of money as the stock priced sored to 100x its prior price in the span of a few weeks. Reddit users, determined to punish the hedge funds for its history of actions that came at the expense of the poor / small investors / the economy, collectively decided to hold the stock rather than let the hedge funds clear their short. One of those hedge funds, Melvin Capital Management, may have used the powerful relationship of its parent company, Citadel Securities, to force Robinhood (a stock buying app) to temporarily block the sale of GameStop stock for Melvin’s substantial financial gain. Lawsuits have been filed, and the story is not yet complete.
This article will be updated as the saga unfolds. Please consider sharing it with your friends and staying connected via Twitter or RSS feed when new posts are completed.
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