Several government entities in the United States are looking into the recent volatility of stock prices for the company GameStop (GME) as well as the decision made by brokerages like Robinhood to restrict the trading of GME stock. The question is if there was any market manipulation involved by the traders and if brokerages had complied with federal regulations. How did we get here, what exactly happened and what happens now? Let’s break it all down.
This story beings on the Reddit forum WallStreetBets. A forum where every day retail traders gather to exchange information and tips. The members of the forum noticed that many wall street hedge funds were shorting the stock for the company GameStop. The retail traders decided to collectively invest in the company as a way to make money and give the proverbial middle finger to massive hedge funds. The decision by these investors to buy the stock triggered what is referred to as a short squeeze. At one point the price of GameStock shares soared to $483, up by more than 2700% from $17 at the start of the year. Currently, the shares are priced at $52.
What is short selling or shorting?
Shorting is a trading concept where an investor bets on the price of a stock falling to make a profit. Short traders will borrow stock from another trader and sell it when the price is high. Once the price drops, they buy the stock back and return it to the person they borrowed it from. The difference in price is pocketed as a profit. Imagine that there is a Company A whose share price is currently $10; trader Joe knows that Company A is not doing well, or strongly believes that the price of Company A's shares are going to drop, so trader Joe borrows 10 stocks in Company A from trader John. He immediately sells the stock at $10 and earns $100. As predicted the stock price then drops to $7. Joe buys 10 stocks back at $7, spending $70, and returns the stock to John. Joe earns $30 as a profit.
Why did Redditors choose GameStop?
GameStop is a brick-and-mortar chain that sells video games. As streaming services and online retailers have entered the space, GameStop’s business has been faltering. The situation is only expected to get worse. Think, Blockbuster as Netflix started to gain popularity. For a few years now Wall Street hedge funds have consistently bet against GameStop’s shares and earned a profit.
At the height of its popularity between 2012-2016, GameStop was a popular destination among gamers. In 2012 the company earned a revenue of $600 million. Many from Reddit's online community have a soft spot for the company and good memories of visiting their stores. This may have sparked the interest in the firm's shares by the amateur investors.
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Did wall street lose money on GameStop?
When the Redditors decided to collectively invest in GameStop shares, they drove the price of the shares higher. This triggered something called a short squeeze. As the price of GameStop increase, investors who had bet against the stock had to quickly buy it up or risk losing even more money if the prices continued their upward trend. As short traders buy up the stock to forestall further losses, they drive up the prices even more. Let’s look at our earlier example again, Joe borrowed 10 stocks in Company A from John. He sold them at $10 hoping the price would fall and he could buy them back cheaper. He has to return that stock to John. Imagine, if instead of falling to $7, the price increases to $13. Now Joe has to pay $130 to acquire the 10 stocks he has to return to John, this means he will lose $30. Joe could choose to wait longer and see if the price falls again, but he also risks that the price might increase even more.
The move by
amateur investors on Reddit was unprecedented. Initially, the general perception
was that wall street had lost a lot of money due to GameStop and that small
investors had managed to get one over the institutional investors and earned a
profit. However, as more information has been gathered, experts believe that
the volatile trading around GameStop may actually have benefitted big players
in Wall Street. There are some hedge funds that had to pay for shares at a
higher price to cover their short bets, however as the price started to trend
higher, other hedge funds may have taken calculated risks to earn a profit from
the volatility. Former economic advisor to President Bill Clinton, Robert J.
Shapiro said, “You have hundreds of millions of shares being traded at prices
of $200 to $300 a share,” Shapiro said. “The Reddit crew cannot afford to play
in this game in any significant way.”
Redditors on the other hand, have not stopped at GameStop, the amateur investor community has chosen to pull the same trick with other companies that they believe Wall Street shorted. These include the likes of Bed, Bath and Beyond, Blackberry and AMC theaters. The question of who ended up earning a profit during this entire saga will be of import to the government entities that are investigating the situation.
What role did Robinhood play?
Robinhood is a stock trading and investing app. The company positions itself as an app for the masses and its mission is to democratize the financial market. At the height of GameStop’s stock volatility, as some hedge funds were reporting massive losses, Robinhood made the decision to restrict the trading of GME stock. Users would only be able to sell their shares and not purchase them. This decision did not sit well with app users who believe that the company ultimately acted to protect Wall Street’s institutional investors. Many other brokerages also decided to restrict trading in the stock. Retail investors have cried foul and class action lawsuits have been filed against Robinhood, with many choosing to take their money elsewhere.
What happens next?
The US Senate Committee on Banking will hold a hearing to discuss, ‘the current state of the stock market.’ The hearing is being called, ‘Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide’. Reddit CEO Steve Huffman, Robinhood co-CEO Vlad Tenev as well as some prominent Redditors from the Wallstreetbets forum will testify at the hearing.Meanwhile, Hollywood has jumped on the story with both HBO and MGM announcing plans to make a movie. Netflix is making both a feature film as well as a documentary and there is even talk about creating a TV show around the situation. Whether or not any regulatory changes are made following the senate hearing remains to be seen. One thing is for certain, the investment world has fundamentally changed.