Unless you’ve been living under a rock this week, you’ve probably seen something in the news about GameStop stock. The stock went on a meteoric rise from around $18.84 per share to $483 per share. This story, however, is much bigger than GameStop and how this happened is quite literally the stuff of legends. We’re going to unpack this over a number of articles because the number of different topics this action brings up is pretty remarkable.
First, what happened:
Some hedge fund guy bragged about a short position in Game Stop. A CFA who has a penchant for investing in deep value positions posted his feelings on GameStop on Reddit… and we all know what can happen when social media gets involved. As it bounced around social media the idea took root and it devolved into a mob of let’s stick it to hedge funds and make money in the process. This led to many smaller investors to buy the stock en masse causing the hedge funds to lose money on their short positions. Then some trading platforms got involved to stem the mania or take away people’s rights (depending on how you look at it). Of course, this had to become political as Ted Cruz and AOC started Tweet fighting. Now, the stock is still going up and everyone is still pretty much going nuts.
So, the real question for episode one is: “How can a bunch of people on Reddit buying a stock be bad for a hedge fund? “
The answer to this lies in understanding what a short sale is. (Please keep in mind this is an oversimplified example and the full breadth of what is going on will take time to sort out.)
Shorting a stock is basically borrowing a stock and selling it in hopes that the price of the stock drops. If this works out you can then buy the stock for a lower price than you paid for it, you give that stock back to who you borrowed it from and you keep the difference. So, you short 100 shares of XYZ company at $10 per share you now have $1,000, but you also owe that stock back to your borrower. If that stock drops to $5 per share, then you can buy it for $500 and give the 100 shares back. You then get to pocket the $500 difference you made.
The flip side of this can get ugly though. So, you sold your borrowed XYZ at $10 but people pumped up the stock and made it go up to $50. Now to buy it back would cost you $5,000 and you would have lost $4,000 on the trade.
Ok so why not just wait out the movement?
First, you can theoretically actually go negative on a short position forever if the stock keeps going up. Not only have you lost your investment, but you could owe considerably more money than you originally invested to cover the position. So, in this case Mr. Hedge Fund could see the value drop massively as the he would have to buy back the stock for significantly more than he borrowed. This can (and has) led to many funds closing out their short positions.
The other thing has to do with who they borrowed the stock from. Borrowing that stock is done on “margin”. Margin just refers to being loaned money or securities but doing this comes with rules. If you’ve borrowed stock, you are required to maintain a certain percentage of actual value in the account; this is called a margin requirement. If the value of your position drops below this margin requirement you can be required to put in more money or pay up and close the position.
So as the price went up on the shorted stock these hedge funds had to decide if they keep putting money into the position to call the bluff or just pay up and move on. Either way this has been a very bad scenario for them.
This process of rising prices causing short sellers to buy the position is called a short squeeze and that is exactly what the folks on Reddit started to the detriment of people shorting the position. Short squeezes have happened before in the market, but usually not because someone decided to deliberately blow up a short position.
This is history in the making folks. Joe Blow fighting the establishment. We don’t know the implications quite yet, but we’ll get into some of that next time around.