Image description: Phone on top of a messy stack of papers, magnifying glass over stock exchange information
In late January, the price of GameStop shares rose steeply from just under $20 to a peak of over $450 per share. GameStop –a dying game retailer already suffering before the pandemic – suddenly achieved a higher share price than Apple, causing near-catastrophe for hedge funds like Melvin Capital. The key to this extraordinary event was a group of Reddit users on r/WallStreetBets: a small subreddit that has since undergone exponential growth.
This near-catastrophe occurred because of the stock market. The basic stock market is an exchange where people can buy and sell stocks or shares in a company’s ownership. If someone owns all stocks in a company, they are entitled to all profits, and if the company is liquidated they get all the money from that sale.
If someone owns only a third of all stocks, they get a third of the profits. The rules surrounding supply and demand mean that selling stocks will increase the supply, driving the price down, whilst buying stocks will increase demand, consequently driving the price up. Since most people want stocks in order to sell them for a profit, a small drop in price might make other traders sell because they fear losing money, while a rise might make them buy because they see it as potentially profitable. This then decreases or increases prices further.
Theoretically, there is a maximum profit that can be made, but no maximum loss.
Another key concept is short-selling. This is when a large trader with a lot of credit borrows stocks from a dealer-broker who already owns them, then sells them off, driving down the price. As this lowers others’ expectations, other investors may also sell, and the price will fall substantially further before eventually growing once more. If the trader buys the stocks back when the price is low, they can give them back to the dealer-broker, and keep the difference as a profit.
Shorts are often disliked for this practice; perhaps most prominently by Elon Musk (who also happens to be a popular figure on r/WallStreetBets) who has often railed against them on his Twitter, accusing them of artificially deflating Tesla share prices. However, the act of shorting also has high risk: if the price instead rises, the short is still obligated to buy back and return the shares, losing money. Theoretically, there is a maximum profit that can be made, but no maximum loss.
The subreddit’s users are, individually, small-time retail traders. They used apps like Robinhood to buy relatively small amounts of stock, but collectively they had the means to make a significant impact. Having identified GameStop, and to a lesser extent AMC and Nokia, as short targets for hedge funds, they decided to reverse the course. Instead of being driven artificially down, the users bought GameStop shares en masse, driving up the price.
So, as momentum grew on the markets and on social media, more investors (particularly inexperienced retail investors) purchased stocks, resulting in an enormous spike in share prices. This forced hedge funds like Melvin Capital to draw in billions of dollars of extra funding so they could afford to buy the shares back. Even after Robinhood and other trading apps banned further purchase of GameStop shares, the price fell slowly, with many amateur traders repeating the mantra of “hold the line”.
The original GameStop short had reached the point where more shares were being shorted than actually existed; GameStop share prices were never realistic to begin with.
Looking deeper at this event, a few things become clear. First, the original r/WallStreetBets users understood something that certain later, more financially illiterate, investors did not: this was not a long-term money-making scheme. Whilst some traders did see their wealth increase as a result of the surge, most were less fortunate. To begin with, many of the ringleaders often had prior experience in the finance sector, and on some level they grasped a fundamental truth in economics: the stock market is imaginary. Its prices come from a complex and complicated system of expected future value which has practically zero bearing on reality. The original GameStop short had reached the point where more shares were being shorted than actually existed; GameStop share prices were never realistic to begin with.
More pressing is the question of why investors continued to join in. For some, there was a clear understanding that this was unprofitable; much of the rhetoric was focused on “sending a message”. Investors believed that making a loss on GameStop shares was a worthy endeavour because it allowed them to spite large hedge funds. Ironically, the biggest profit by far appears to have gone to BlackRock Capital, the world’s largest asset manager. However, others seem to have genuinely bought into GameStop shares, sometimes at over $300, with the belief that it could still be profitable.
To say that this was a simple rebellion against rich stockbrokers is clearly an oversimplification. It certainly was driven by animosity against the elite short sellers: a sort of Occupy Wall Street-style anti-elitism, but there were other elements. Financial illiteracy played a role, especially in keeping up the momentum long after the initial investors had poured all their available funds into buying. Later investors believed they could join in on the scheme, not understanding that the prices were close to their peak, underscoring how inexperienced many of the amateur stockbrokers were.
In summary, the GameStop surge was two things. In one aspect, it was a kind of protest, driven by the same sort of animosity that motivated the Occupy Wall Street protest. For the other half, it was a particularly risky get-rich-quick scheme, driven by incredible returns for the lucky first few but highly dangerous for those following. Ultimately, for all the talk of “sending a message”, it is unlikely anyone on Wall Street will listen. As entertaining as it might have been, the majority of investors will end up with substantial losses instead of gains.
Image Credit: Olya Kobruseva, Pexels