BU Today: Why did GameStop’s stock go down in the first place?

Fernando Zapatero: GameStop was a struggling company, [like] many other retailers facing competition from online sales. The COVID-19 pandemic and the required closure of stores (and restaurants, and movie theaters…) made things harder for them and precipitated an even faster fall of its stock price.

Can you explain in simple terms what’s involved in shorting stock?

Shorting (or short selling) consists of the following strategy: if you think a stock is going to go up in price, buy it and hold it until, hopefully, its price goes up and you can sell it at profit. This is a normal purchase (long position). What if you think a stock is overvalued and its price is going to go down? Short selling is a possibility. To do this, you borrow the stock from someone who owns it. Then you sell and collect its price. If you were right and the stock price drops, you then buy it back at a cheaper price than what you initially got for it, return it to the lender of the stock, and keep the difference. 

In the case of GameStop (and many other companies—this was a huge issue in the case of Tesla) some investors thought that the price would keep going down and decided to short sell it. Some hedge funds (and other investors) are very active in shorting stocks they think overpriced. GameStop had dropped in price, but some people thought not far enough and shorted it.

So while these guys were expecting to short the stock, what happened instead?

A further element to characterize shorting: it is not as easy as it is to buy. To buy a stock you pay the price and then you are done. You can hold the stock for as long as you want. 

But when you short the stock, you first need to borrow it. And for that, you have to pay a lending fee, sometimes steep. Also you need to deposit collateral to guarantee you will be able to buy it back. That collateral is often money that [carries] an interest rate. 

What happened in the case of GameStop and other companies is that when the price was very cheap, some investors found it attractive to speculate on it because of the possible gains. [In other words], you can buy many shares with a relatively small amount of money, and if the prices recover a little bit you have a substantial profit. It is a bit like playing the lottery: you don’t have to pay a lot to buy a ticket, but the gains can be substantial. 

Some people were doing this through options, which is a more technical strategy, but has a similar effect, even bigger: you need less money to possibly get substantial profits. But as these people were buying, they put pressure on the hedge funds shorting: when people buy, the price of the stock goes up and the shorters have to increase their collateral. Some shorters decide it is too risky and buy back the stock to return it, cutting their losses. The fact that they buy it back means the price of the stock goes further up, putting more pressure on other shorters.

In the case of GameStop, some of the people who were buying the stock realized this was having an impact on the shorters and coordinated through Reddit to buy more and put further pressure on the shorters. As some of the short sellers (preferred term, at least for class) have very large short positions, they had to buy back a lot of stock, which had a huge positive price effect on GameStop. This created a feedback effect of more investors jumping on GameStop and more short sellers having to buy it back. This situation is called “short squeeze.”

One of the big Reddit threads, the Wallstreetbets Forum, got pulled down for fear it was wreaking havoc. Do you have any words of caution?

The beginner investors are buying, not short selling, GameStop (or buying “call options” on the stock, a similar type of investment, but much riskier). The danger is that they are investing in a stock whose price makes no sense—this is a company losing a lot of money, with very poor prospects, and whose stock price would only be justified if they were making a lot of money. The stock price might collapse, and these people can face significant losses. Right now, the players who are bearing most of the losses are the hedge funds that are short selling the stock.

Little guys normally aren’t protected when one of their investments fails: e.g., in a tragic case a few months ago, a 20-year-old investor lost more than $700,000 by trading options on Robinhood, and he ended up dying by suicide. Without protections in place for smaller investors, isn’t the anger some people are feeling towards hedge funds such as Melvin Capital, which was bailed out by a fellow hedge fund, understandable?

Some of these small investors have made a lot of money, and more worrisome, some of the ones who have bought the stock at high prices are facing considerable risk. Chances are the stock will go back to what would be normal for a company losing money and without an obvious path to survive, in which case the investors who bought at the high prices will face significant losses.

Regarding your question, it is just a matter of fact that larger companies (financial or otherwise) have more options to get out of trouble than smaller companies or individual agents. That is why consumer protection is so important. A true capitalist economy would require an even field for all participants (which leads to a healthy competition and ensuing benefits). As it is, the field is by no means even, and the larger agents have huge advantages. 

In this particular case, we do not know the terms of Melvin Capital. They have received a cash infusion, but it probably carries a substantial interest rate to compensate the lender from the risk that Melvin Capital will suffer further losses and might not be able to repay the loan. Melvin Capital might survive this episode, but it will likely have to pay a substantial price for it.