The year 2020 was unprecedented. Reflecting on the global impact of the pandemic is disheartening. The year claimed various initiatives, small businesses, and companies, many coming to a sudden halt. The case was no different with GameStop.
GameStop has been losing money for awhile, losing money on an outdated business model. For those unfamiliar, GameStop largely sold retail (physical games and accessories) with the majority of their profits coming from Q4 (i.e. the winter holidays). However the target audience has mostly moved on to buying digitally and meanwhile, other retail titans make it easy to purchase physical games without leaving the home — in addition to myriad other products (e.g. Amazon, Target, Walmart). GameStop is almost too niche for its own good.
Long story short, GameStop has been decreasing in value every year, making it a ripe target for hedge funds.
What’s a Hedge Fund?
A Hedge Fund is an investment that trades assets to makes subsequent high-risk, complex trades to increase profits. To understand how the trading makes a profit, you need to understand the “short sell.”
Okay… I’ll bite. What’s a Short Sell?
Glad you asked, a short sell is what happens when you think a stock is “overvalued”, so you “borrow” stocks so you can sell it at its high price in hopes that you were right and it was overvalued and, as the business collapses, you can buy it back at a lower price — pocketing the difference.
So for instance, if you borrow stocks currently worth $100, and sell them. Then, if the business starts to fail and those stocks are now worth $70, then the investor buys those stocks back and returns them, pocketing the $30 difference.
Moving on from the short sell, there’s another piece in this puzzle: Options.
What are Stock Options?
Something you may have noticed above is we haven’t talked about the “owner” of the stocks. There’s the hedge fund investor who borrows the funds as they’re seeking a short sell, but what about the person they’re borrowing from?
This where options come into play. An investor can — they are not obligated to, but they can — agree to buy or sell a stock at an agreed upon price and date. There are “puts” — a bet the stock will fail — and “calls” — bets the stock will rise.
For instance, there’s a strike price, i.e. “once my stock, currently valued at $10, reaches $15, sell it.” Options are relatively low stakes because they usually come with an expiration date as well.
In the end, you can buy a call option that says you’ll buy the stock if it rises — knowing it won’t — and collect the premium since they expire…
If however, the stock prices do start to rise and people start buying up cheap options, and more people see the value and buy up more cheap options, then what you have is increased demand and limited supply.
In the case with GameStop, many of these hedge fund investors were then told — from the people they’re borrowing from — to start selling their stocks which meant that the hedge fund investors either needed to sell other stocks, put up their own money, or try to buy back the stocks now at an inflated price. This meant the hedge fund investors that once sold and bet on $11 stocks being next to worthless, suddenly needed to buy back those borrowed stocks at over $300 because they wrongly predicted their value.
What Caused The Rise And Fall
The collapse of the GameStop Company prompted traders to take advantage of the company’s stock market by buying the shares without selling them. The short-selling investors had nothing to trade with as the company’s shares were out of stock. In simpler terms, the short seller investors operated on a loss since they had to invest twice; after selling a share, they had to buy again at a higher rate. Normally, the short selling method favors the investors if the stock value decreases. On the contrary, a higher rate prompts the investors to buy the stock at a higher rate resulting in huge losses.
Maybe you’re imagining what happened to the investors running at a loss at the expense of a rapidly increasing value of the shares? It leads to a ‘short squeeze’ — or in GameStop’s case, a Gamma Squeeze — that is favorable to traders (many of which were amateurs coming from reddit’s wallstreetbets). What seemingly started as a joke — a meme — rapidly turned into a crushing reality for many hedge funds.
Many lawmakers and business owners however are considering changing how the stock market works. People on both sides of political lines think this type of phenomenon needs to be kept in check since if an internet group can artificially inflate the value of something, what consequences can that have in the long-term. The main intention of these traders is to accumulate funds through high-risk strategies from the large-scale investors to acquire more capital.
Recently, the private investors adopted the call actions to increase the value of the share. However, this action has only worsened the situation. The call options allow the investors to invest in a pre-set value on the current market rates shares. When the stock rises, the rates increase to prompting the seller to trade at a profit. The call option is not a solution either since the uncertainty of the GameStop shares is real.
At this point, this story is far from over and given the national optics on it, it’ll certainly be a moment in history where we reevaluate how hedge funds, short selling and gamma squeezes work.