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Game icon and Policeman holding his hand out to stop traffic in the foreground. Abandoned strip mall in the background photo.

The Gamestop Game

By David J. Haas CFP®
February 1, 2021

By now, I am sure you have heard about the situation with Gamestop. Everyone seems to be talking about it and several people have asked me what I thought. In case you missed it, here is the situation: Gamestop is a company that sells video games and equipment out of brick and mortar stores. Even before the pandemic, Gamestop was not doing well, but the pandemic has decimated its business. A lot of hedge funds and professional investors have been selling Gamestop’s stock short. That means they are betting the stock will go down. But a bunch of amateur investors on a message board on Reddit have banded together to buy the stock which forced a short squeeze. GME, which was $18.84 a share on December 31, 2020, closed at $325 a share on January 29, 2021.

How did this happen? Is it really a David vs. Goliath scenario where ordinary investors got one over on those nasty short sellers? What does this mean for you, me, and the market? I find the situation very interesting, and like many rather technical situations in the news, the media has not done a great job explaining the issue and what it means.

Short Selling

To understand what happened, you need a primer in short selling and how it works. If a professional investor thinks a stock is going to go down because its overvalued or because his/her tarot cards, crystal ball, or any other prediction tools said the shares will go down, they will borrow shares from other investors and sell them. They have to pay interest on the borrowed shares, but they are hoping the shares will go down and they can buy them back later for less money and then return the shares. If I borrow and sell 100 shares for $20/share and a month later the shares have gone down to $10/share, I can buy back 100 shares for $10 and return them to the person I borrowed them from. I just made 100 x $10 or $1000 by doing that.

If short selling is so easy, why isn’t everyone doing it? The truth is that short selling can be very risky. Let’s compare short selling with the normal case of investing.  If I think a stock is going to go up and I buy 100 shares at $20/share my initial investment is $2000. If it was a lousy stock and it went down to $0 because it went bankrupt, I will have lost $2000. This is unfortunate, but not tragic.

Instead, let’s take the short case. As an example, I spend $200 to borrow 100 shares at $20/share (that’s not really what it costs, but the actual cost is somewhere between 0.3% and 30% per year depending on the stock). If I was wrong and the shares double to $40, it will cost me $4000 to get out of this trade. I will have lost $4200. You can see that I lost much more than my original investment of $200. Gamestop didn’t just double. It went up much more. What happens if something makes the stock go up to $100 and I still hold my short position. It will now cost me 100 * $100 or $10,000 to get out of this trade. When you are long on a stock (buy it thinking it will go up), the risk is usually just what you invested. When you are short on a stock, your risk is virtually unlimited. You can lose far more than your original investment.

Because of the risk, short sellers are generally professional investors and hedge fund managers. I have never shorted a stock and I don’t think I will ever do so. The risk of losing a lot of money very quickly is too great.

Reddit

The Gamestop situation originated in the WallStreetBets subreddit. This is simply a message board where members get together to discuss their thoughts on stock trading. As the name suggests, I think most of the members are trading short term and view the stock market more as a place to bet like a casino rather than a place to invest for the long-term. I have heard that many members are amateur, but I would expect members also include professional traders.

What Really Happened with Gamestop

Gamestop is not a company with great prospects and a number of short sellers felt the stock was overvalued. So, they shorted the stock. In fact, so many traders shorted the stock that most of the stock’s float (number of shares available to trade) were borrowed. It turns out those borrowed shares were borrowed again and each share had been borrowed multiple times. Why did all these supposedly smart Wall Street insiders all hold short positions in the same stock? Its because there aren’t that many new ideas out there and they probably all discuss their own trades with one another on their own message boards and they piled on to bets that Gamestop would go down.

Short Squeeze

It turns out that a lot of short positions in a stock can actually keep the stock from going down. This is counter-intuitive, but all those short sellers need to eventually buy back the shares to return the borrowed shares. When that buying occurs, it pushes the stock up. If all the short sellers need to buy back shares at the same time, then it is called a short squeeze because the rising stock causes other short sellers to buy. A short squeeze can push the stock up violently. This is exactly what happened with Gamestop, one of the world’s biggest short squeezes.

WallStreetBets

In the US, figures on the borrowed shares in every company is published by FINRA, the stock market self-regulation authority. The message board participants figured out that Gamestop was the most heavily shorted stock. If they could create the right conditions where the stock starts to go up, then they might be able to create a short squeeze which would just push the stock up more as short sellers buy it back. They claim that they were trying to hurt the evil short-sellers, but I’m not convinced. I think the individuals who originated the discussion were simply trying to light a match that would let the tightly wound spring of all those borrowed shares unwind. They certainly profited handsomely. I heard an interview with one participant who turned the $200,000 in his house down payment fund into $4,000,000. He took a terrible risk because he invested every dollar to his name in this scheme. What if it didn’t work?

Is It Legal?

Something somewhat similar happened with Tesla in 2018. There was a big short position in Tesla and Elon Musk said some false things about taking Tesla private just to start a short squeeze. The short-sellers had to close their positions, forcing the stock up. The SEC opened an investigation. It was settled with Elon Musk having to step down as Chairman for 3 years and paying a $20m fine. If the Gamestop CEO was manipulating WallStreetBets, then it would clearly be illegal. But if a bunch of individuals just get together on their own and tell other people to do the same thing, I think it will be very hard to say they did anything wrong. The short-interest data is published. If you or I had been smart enough to notice it, we could have bought the shares and tweeted about it, trying to encourage interested to  do the same thing. Its not illegal to take advantage of a market inconsistency we can see with public data.

Morality

Those message board participants were saying all sorts of terrible things about short-sellers and talking about how they were doing this to get revenge for the 2008 panic and housing downturn. To me this talk is completely crazy and pretty much fact-free. Short sellers identify opportunities when they think a stock is too high and is going to go down. Honestly, this helps to set prices properly in the market. Its not evil, even if you disagree and think the stock will go up. The housing bubble was not the fault of short-sellers. They noticed the bubble in the housing market and some of them made a lot of money when it burst.

Aftermath

The short sellers are not going away although I think they will be more careful in the future. They will try not to create the easy conditions to create a short squeeze. The Reddit WallStreetBets community may try this game with other investments. I hear this morning that they are trying it with Silver. I think they will very quickly find the limits to their powers. We are going to hear some stories of people who lose their life savings or their mortgaged homes when a security they are trying to push up actually goes down. The risk and reward tradeoff is very present here. If you take too big a Wall Street Bet, you can lose your shirt!

Remember that investing is very different from trading. What I do for my clients is investing over the long-term to help clients meet their goals. The Gamestop situation is pure speculation that, while fascinating, has nothing to do with meeting your long-term goals in a prudent manner. If you want to discuss short squeezes, your investments, your goals, or any other subject, please contact me. Our website is www.cereusfinancial.com.

Important Information

Cereus Financial Advisors, LLC (“Cereus”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Cereus and its representatives are properly licensed or exempt from licensure.

This article contains my views and opinions, which are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.  Past performance shown is not indicative of future results, which could differ substantially.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

Investing always involves risk and one of the most important aspects of investing is balancing risk with your own risk capacity and tolerance.

In writing this article, I’ve relied on third-party sources that I believe to be accurate, but I cannot guarantee their accuracy or reliability.

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