By Christina Gohl

Introduction

When the markets opened on January 3rd, 2020, Gamestop (NYSE: GME) was trading at $5.88 USD/share. As a mall-based retailer in the middle of a global pandemic, selling physical video games in an industry where games could be purchased and downloaded digitally, Melvin Capital, a fund on Wall Street felt Gamestop was ill-positioned to survive and shorted the stock. However, there were still some believers that Gamestop could turn around their business. Ryan Cohen, a former CEO at online pet-food retailer Chewy Inc., saw the opportunity for a revival. He had experience taking a brick and mortar business digital and felt the opportunity was ripe for Gamestop to digitize their business. So Cohen started buying GME shares (United States Security and Exchange Commission). At this point (August 2020) the stock was trading at around $5/share. Cohen’s investment fund proceeded to acquire 12.9% of the outstanding shares over the next few months and began challenging the Gamestop board to make some improvements. Little did he know, he was about to become the catalyst for one of the largest short-squeezes in history.

The Short Position

The Players in a Short Sell

To implement a short strategy there are four key players involved: the investor, the brokerage (market maker), the settlement house (clearing house) and the exchange. The investor themselves cannot directly transact their trades on the stock exchange. To accomplish that, they must work with a brokerage. The brokerage will allow each investor a certain amount of margin (credit) within a margin account through which the investor can request trades (Chen). Once an investor opens a short position, the brokerage makes the trade on behalf of the investor. This is when the money is exchanged, typically done through a settlement house, which settles the financial transaction.

What is a short position?

Next, let’s explain the mechanism of a short position. When a stock is shorted, the investor borrows a stock with the expectation that its value will decrease. That same investor then turns around and sells the stock to other investors who are willing to pay the market price for the stock. The short investor is betting that the price of the stock will decrease in value before they repurchase the stock and that they will make money on the difference. The short seller will see a more significant upside the more the stock falls in price, however, there is significant risk: a short sell has unlimited downside. Given the fact that an asset (the share) can theoretically increase in price to infinity, and the short seller has the obligation to return the shares at the market value, a short sell can go very poorly if a stock price rises dramatically against the short-seller’s expectations. As such, this is a high risk/high reward strategy typically used only by sophisticated professional investors.

How is a short sell used?

A short strategy is employed for two key reasons. First, as speculation: essentially a high risk bet on the future movement of a stock. A speculative short investor is betting that they will profit from the fall in value of a certain stock. This investor is very focused on price fluctuations and is usually employing a short-term strategy to generate returns in falling markets. The second use of a short strategy is an advanced strategy to hedge against the downside risk of a long position on the same stock (Chen). By having both a long position (the opposite of a short position) which would rise and fall with the value of the stock and a short position which would do the inverse, this hedging strategy balances the portfolio and limits risk. Within a short position there are certain underlying requirements and mechanisms to understand. The first is that a short short sell can be held indefinitely as there is no limit to how long a position can be held for. The second is the maintenance margin. Short investors are not typically paying cash for their investments. Instead, they purchase using a margin account held by a brokerage. Regulation has been put in place that requires a minimum amount of capital be held in reserve in the margin account to reduce the credit risk of the investor for the brokerage who holds the margin account. In the case of the New York Stock Exchange (NYSE) this minimum is set at 25% of portfolio value (United States Securities and Exchange Commission). This is only the minimum requirement, however. Brokerages are free to set their maintenance margin at any level at or above 25%, as well as change their requirements in the face of increased risk. If an investor fails to maintain their maintenance margin, the brokerage will make a margin call, immediately demanding a deposit of assets. If the investor fails to make the required deposit, the brokerage will begin closing the investor’s short positions until the margin requirement is reached (Chen).

GameStop in 2021

Contrary to Ryan Cohen’s optimism towards GameStop’s potential, many in the market felt GameStop was overvalued. For their fiscal year ending Feb 1 2020, GameStop posted a net loss of $275 million on revenues of $5.2 billion (GameStop Corp.). Andrew Left of Citron Research was one of the most vocal critics of GameStop’s valuation (McGrath). These critics felt confident GameStop shares were going to decline and shorted the stock. However, unlike when shares are purchased, there is no limit to the amount of short positions that can be taken against a stock. The result was that investors shorted more than GameStop’s entire amount of shares outstanding, acquiring a short interest of 71.2 million shares against GameStop’s outstanding 69.7 million shares (United States Securities and Exchange Commission). As of January 4th, 2021, GameStop’s price had declined slightly from 2020 closing to $17.25 USD.

The Wall Street Bets Retail Investor

What Andrew Left failed to account for in his valuation of GME was “the Reddit effect”. The intention of the stock market is to create market efficiencies. The efficient market hypothesis states that stocks trade at their fair market value on exchanges, that is, that share price reflects all information. However, this theory relies on the premise that humans are purely rational beings: that when they buy and sell stocks, that they do so after careful data-based valuations. What if that weren’t true? What if there were a large number of people sitting bored at home during a pandemic, with access to margin accounts, who wanted to trade stocks with their friends on Reddit? Bloomberg calls this the “boredom market hypothesis” (Levine). If this hypothesis is true, then stock valuations may be much more difficult to predict: a simple “meme stock” on Reddit could cause the hive mind to rally behind companies seemingly irrationally and send share prices soaring.

Wall Street Bets

Wall Street Bets started out as a little-known subreddit on the forum-style social media platform named Reddit. The purpose of Wall Street Bets was to create a community of guys who wanted to brag about their YOLO (you only live once) bets in the stock market. This is not a subreddit full of sound investing advice, but rather a community of self-named “degenerates” who make entirely irrational financial bets purely for entertainment value. Over the years, the subreddit became more popular (its current subscriber base stands at 8.4 million subscribers, up from under a million in the last 2 months). All of a sudden, what started as a place to communicate largely through rocketship emojis about the “tendies” (slang based on chicken tenders that can be purchased with money, A.K.A. money) they made or lost in the market that day, the subreddit began to have a following large enough to move markets. However, one thing Wall Street Bets is decidedly not are professional investors on Wall Street. There is an inherent, us versus them mentality in the community and an ingrained disbelief in the assumed logic of company valuations. Redditors invest because they like a stock or their friends like a stock, no further evaluation required. A sure way to irritate the community is to bet on the failure of a company: Wall Street Bets despises the Wall Street cynicism inherent in short strategies. So when they caught wind of the large short position held against one of the retailers they grew up with, GameStop, this got a few redditors angry. While Wall Street Bets celebrates the YOLO investment, this doesn’t mean this group of retail investors can’t be sophisticated. They quickly surmised that the short positions outweighed the float of GME and saw the opportunity for a short squeeze. However, in no instance did they suspect how large of an impact they would have.

The Reddit-Fueled Short Squeeze

The short-squeeze began with a few redditors buying call options. A call option is a right, but not an obligation to purchase a stock at a set price (strike price) in the future (at maturity). The call option increases in value when the underlying asset (in this case GME stock) increases in value. A call option allows an investor to gain leveraged exposure to a stock increasing their potential return in comparison to a standard share purchase. The call option is also typically sold for much less than the value of the asset, and is as a result a good strategy for someone who wants to take a lot of risk but only has a small amount of money, for example, your average Wall Street Bets investor.

When a call option is placed by the investor, the market maker (brokerage) would hedge its market exposure by buying the asset (GME stock). The amount of underlying shares the market maker buys to hedge the option is called the “delta”. As the stock goes up, the market maker would buy additional stock to adjust the hedge upwards to reflect the increasing value of the call options. The change in delta that occurred as the market maker bought more stock is called the gamma. As a result of the market maker buying stock to hedge the call options, GME price began to increase. As a result of both this and the hype on Reddit as redditors celebrated their call positions, more redditors jumped on board. This resulted in more call options being purchased, more shares being purchased by market makers and GME share price soaring from $19.95/share on January 12th, 2021 to a peak of $347.51 on January 27th, 2021.

As a result, the Wall Street hedge funds who owned GME short positions were forced into a short squeeze. To illustrate this effect, here is a simple example:

1. Let’s assume the fund held $1 billion in short positions.
2. From January 12th to January 27th, GME stock value increased 16.42 times.
3. The fund’s short position would now be worth $16.42 billion.
4. This increase results in a similar increase of maintenance margin. However, due to added volatility maintenance margins were increased at an even faster rate.
5. This left funds with two options: inject capital to hold or close their short positions by purchasing GME stock.
6. In an effort to limit their downside, funds purchase GME stock. Due to the lack of available GME shares willing to be sold this forced short positions to close at increasingly higher and higher stock prices: a short squeeze.
7. This repeats until volatility is reduced.

In reality, the hedge funds owned more short positions than stock available. This meant that there was a percentage of their short positions they could not close. This resulted in billions of dollars of losses. Melvin Capital fund’s (a large investor in GME short positions) net asset value dropped 53% in the month of January (McIntosh). This meteoric rise in GME share price sent shockwaves through Wall Street. While the internet rejoiced at the take-down of Wall Street by Reddit, Melvin Capital scrambled to stop the hemorrhage of capital in their short positions.

When will the game stop?

Robinhood Limits GME Trading

Robinhood is a free online trading platform built on the democratization of investing. A user could sign up to the Robinhood platform and access a margin account, allowing them to trade stocks, within a day. This led to a significant increase in retail investors. Robinhood has developed a brand around helping the average Joe trade with the “big boys” on Wall Street and boasts “Let the people trade” on their social media. Robinhood is popular amongst Redditors, specifically on Wall Street Bets. While the exact figure is not precisely known, it is suspected that a large percentage of Robinhood’s user base is redditors and that the company’s Unicorn status was largely achieved through the good reputation it held amongst those on Wall Street Bets. So the betrayal was swift in the Reddit community when Robinhood halted the purchase of GME (Wilhelm). As Redditors quickly learned, there were significant financial ties between Robinhood and many of the funds shorting GME (Wright). For example, Citadel, a significant investor in Melvin Capital also happened to be Robinhood’s largest customer. The “trading platform of the people” image that Robinhood had cultivated so carefully was instantly unravelled: Robinhood’s 4 star rating on google dropped to 1 star in a matter of days as hundreds of thousands of angry customers, many Redditors, posted scathing reviews.

Lawsuits and Government Action

As a result of the trading freezes, many retail investors lost money in the wake of significant volatility in GME stock and their inability to trade freely. With limited options, retail investors initiated class-action lawsuits against Robinhood (Alfonso). At the same time, the ‘David versus Goliath’ story was being played on every major news network and propagated on every major social media platform. Politicians jumped on board, eager to gain popularity amongst voters and supported by a newly elected U.S. democratic government.

Where do we go from here?

In a matter of weeks, the perception of an efficient market has changed. Amidst growing concern for a stock market that is increasingly decoupled from reality, the Reddit short squeeze took power back into the hands of the people. While this has garnered some hope amongst the populace that the market can be brought back to reality, it is too soon to truly know what the effect will be. Will hedge funds simply revise their short strategies? Will the government impose legislation on shorts? Will limits be imposed on the retail investor? Only time will tell.