Broker Check

GameStop, Reddit, Hedge Funds and the Big Short Squeeze

February 01, 2021

"Every age has its peculiar folly; some scheme, project, or fantasy into which it plunges, spurred on by the love of gain, the necessity of excitement, or the mere force of imitation."
– Charles Mackay in Extraordinary Popular Delusions and the Madness of Crowds in 1841

"In the short term, the market is a popularity contest. In the long term, the market is a weighing machine."
– Warren Buffett


I hope this finds you well!

Last week, you could not go anywhere (online, of course - most of America is still working from home after all) without hearing something about the GameStop/Reddit/HedgeFunds/WallStreet saga. Because this story is so unique and strange, I thought it would be helpful to summarize how we got here and where we may go moving forward.

How we got here

The story really begins with the COVID-19 pandemic, believe it or not. Over the past year, more new investors have opened brokerage accounts than ever before, to the tune of 10 million new retail trading accounts. Early in the shutdown, when people had little to do and betting on major sports was no longer an option, trading activity began to surge. These retail investors took advantage of government stimulus checks and began to make aggressive "bets" on companies that had been out of favor for a while (more on that in a moment). Add to this the increased popularity and accessibility of app-based and "free" trading platforms, like RobinHood, as well as online forums like Redditt where members can share information, and you have a perfect storm. A note on "free": many users surprisingly found out this week that they are the product and their data is sold, hence the platform isn't really free.

Enter GameStop (GME). For months, both as a business and a stock, GameStop has struggled. It has closed down about 1,000 outlets since 2019. From 2017 to last summer, shares fell from $25 to $4. Hedge funds began "shorting" the company's stock, which means they were betting the stock price would fall, and members of a subgroup of Reddit, called "WallStreetBets" began to notice. Collectively, many members began to use options investing in the stock, which pushed the price up, eventually hitting almost $500 before reversing course. At one point, the stock was up about 1600%! There were other out of favor stocks involved in this plan, but GME was the largest by far.

Short-selling and the big "short squeeze"
As mentioned above, investors will short a stock when they believe the stock is over-valued and will therefore drop. The process works as follows: investors borrow shares, sell them for the current market price, wait for (hope) the stock to decline, then buy them back at a lower price and return them to the original lender, pocketing the difference in price as profit. Whereas when you buy stocks "long", your loss is capped at your original investment, with short-selling, there is unlimited loss potential, as no ceiling exists for the stock price. So back to GME, when the stock was parabolically increasing last week, hedge funds which had shorted it began to panic seeing their losses accumulate into the billions. They were forced to liquidate some of their big-name stocks to generate cash to cover their short positions. This is the big squeeze, and why, while names like GME and other stocks rose last week, we saw the broader market - the S&P500 - sell off.

Where we go from here

While no one is sure exactly how this story will play out, we will keep an eye on both the regulatory and market aspects moving forward. Regulators will probably impose new rules around retail investing including enhanced disclosure requirements for options trading and general investment risks. Margin (ie. borrowing) rules could change, and app-based brokers will need to enhance their platforms as they have been under pressure with the recent increase in trading activity.

From a market standpoint, volatility will probably continue as retail investors have become a larger component of overall daily trading activity. While there is certainly bubble activity popping up in a group of stocks, we don't believe they represent a sign of a broader market bubble. After a 72% rally in the S&P500 Index from March of 2020, maybe it's time simply for a break.

As always, let's focus on what matters most and on what we can control. We are long-term investors, not day-traders. Thank you for the trust you place in my team and I. If you have any questions, or we can be of service, please reach out.

All my best,

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.