The Long and Short of GameStop
At this point, I am sure you’ve heard about GameStop (GME) going viral on the internet and in the stock market due to the now infamous r/Wallstreetbets community on Reddit. For days in late January and early February, media headlines tracked the rise and fall of GME stock, and today we want to talk about why that matters and what lessons can be learned from this event.
GameStop is a struggling video game retailer experiencing a slow and painful decline. GME stock was trading at $17.25 (down from a peak of $63.77 in 2007) at the start of the year. Just a few weeks later it peaked at $483 per share. GME is now back to trading around $45. The cause of this price spike is both fascinating and cautionary.
Who was involved?
Redditors – r/Wallstreetbets is a community of investors notorious for aggressive and speculative trading with an irreverent attitude toward investing and general disdain for a “rigged” stock market that favors Wall Street and hedge funds over the average individual investor.
Hedge Funds – Hedge fund managers are also notorious for employing high-risk investing strategies in an attempt to beat the market. One strategy used against GME was ‘short-selling’ – borrowing a stock, then turning around and selling it in a bet that the stock will drop in value and can be bought back later at a lower price, thereby eliciting a profit. However, if the stock rises, the short-seller is forced to pay ever higher prices to repurchase the stock and return it to the investor from whom it was borrowed, potentially exposing the short-seller to unlimited losses.
Reddit users discovered that certain hedge funds were massively shorting GME and saw an opportunity. They leveraged social media to push for the masses to purchase GME stock to artificially drive up the price – and succeeded, generating enough momentum and volume to drive GME up to 30 times its value, in a matter of days. The higher the price climbed, the short-sellers were forced to purchase more stock to get out of their short position, which forced the stock price even higher.
The result is shown in the graph below.
While GameStop stock was still skyrocketing, a handful of brokerage firms decided to temporarily limit trading in GME.
While limiting trading can be part of a normal response to stabilize the market and protect investors, this did not happen market wide. It happened only on platforms commonly used by individual investors. By limiting individual investors’ ability to trade (specifically, to buy shares), some argue that, once again, the system was rigged in favor of the hedge funds. By temporarily limiting the ability of individual investors to buy or trade these stocks, only one “side” was able to participate in trading. Which means, no one knows if this allowed the price of GME to come back down a bit, allowing hedge funds to get out of their short positions with less of a loss, or if demand would have remained high and the share prices could have gone even higher.
These brokerage firms later claimed they were forced to limit trading due to regulations requiring them to have a certain amount of money on hand to cover stock trades, and that they simply didn't have enough cash at the time. But, this caused a second layer of market intervention (or manipulation, as some put it), further muddying the waters of this fascinating event.
Did the Reddit investors succeed?
Yes and no. Some hedge funds were forced to buy back the stock they borrowed at unbelievably high prices and take massive losses. Some novice Reddit investors made millions of dollars. But not all hedge funds lost money, and not all novice investors made money. One hedge fund made $700 million from the stock’s volatility. And countless innocent and uninformed individual investors were lured into a ploy that caused them to lose substantial sums of money, as they may not have understood exactly what was happening, but didn’t want to miss out.
What does this mean for the rest of us?
At the end of the day, we have seen firsthand that a) markets have never been so accessible, and b) information has never been so widely available. The SEC, the Fed, the House of Representatives and the Senate are kicking off formal investigations, so we’ll learn more as more details continue to emerge.
It also highlights some questions about the stock market, both practical and philosophical, that are not new, but perhaps more illuminated and pressing now, such as how it functions, how it is regulated, who it benefits, and so on.
For you, and for us, we continue to invest; we do not gamble. If you treat the market like a casino, not only do you have to pick the right stock, but also the right moment – not only to get in, but often most importantly – to get out. That is a hazardous game. It’s called r/wallstreetbets for a reason.
While it’s far less exciting and certainly not dominating headlines, we believe you are better off investing in the whole market than on individual stocks, through a low-cost, highly diversified portfolio. Rather than taking outsized risks, you can let time and compounding do the work. The US stock market has returned about 10% a year on average, which means a dollar invested has doubled every seven years.1 The path has never been linear, and 2020 evidenced it can still be a rollercoaster, but it’s nothing like the meteoric 14,300% rise and subsequent crash of GameStop… and thank goodness.
1Source: S&P and Dow Jones data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.