What Happened With GameStop?

It’s a bit of an understatement to say that GameStop has been in the news lately. There are a lot of people opining about what is going on, but we want to cut through that and look at what actually happened (we look at what it all means in another article. So what actually happened, and why do we all know GameStop’s ticker symbol now?

To start off, GameStop primarily sells physical copies of video games. By and large, video game sales have pretty much gone online, and it’s unlikely that trend will reverse any time soon. Basically, the prospects for the company are not great. While this is important context, it’s important to recognize that GameStop as an actual company that sells things and employs people has effectively nothing to do with this story. It’s also important to recognize that we are talking about very small companies. To put it in perspective, as of the end of the year, GameStop only represented 0.0026% of the Vanguard Total Market Index ETF (VTI) which tracks the entirety of the US stock market. This means that for every $10,000 you invested in that fund you would only have owned 26 cents worth of GameStop.

What we are going to talk about is everything that happened to the stock throughout January. To make sure that we are all on the same page, GameStop stock had a pretty wild ride throughout the month. GameStop’s share price opened the year at $19, but soared to a high of $483 on January 28^th, and as of this writing (the evening of Thursday February 4^th), it closed the day worth $53.50. So if you owned the stock (and pretty much all diversified portfolios do, just in really small quantities), you would have seen a 2,442% gain from the beginning of the year to the high, and then over the course of the next 5 trading days you would have lost 89% of the stock’s value. Though it is worth noting that GameStop is still up over 180% since the beginning of the year.

Normally stocks don’t do this over the course of a month. So what happened?

In one sense, this a really simple story that we see fairly often, if not quite as flashy. Essentially what happened was there were a number of hedge funds and other investors who were shorting GameStop pretty heavily, meaning that they were betting that GameStop would lose money, and some other investors executed what is called a “short squeeze.” There’s a lot going on here, so let’s break this down.

What is Shorting a Stock?

Let’s start by looking at what it means to short a stock. Shorting a stock means that you are betting that it will go down. To do that, you borrow a share of that stock from someone who owns it, and then you sell the share that you borrowed. The crucial thing is that you are on the hook to give that share of stock back to the person you borrowed it from. When it comes time to return the share, you’ll need to buy the stock back on the market (remember you already sold the specific share that you borrowed). This means that if the stock went down in value it’ll cost less to buy back than what you got when you sold it.

To put an example around this, let’s say that I want to short Company A, and you own some shares of that company. I come to you and borrow the shares, and then immediately turn around and sell it for $100 per share. Some time goes by and I want to close out my short position. To do that I need to give you the same number of shares of Company A that I borrowed from you, so I need to go out and buy them back. In the meantime, the company’s share price has gone up to $110, this means that when I buy those shares back, I’ll lose $10 on every share that I shorted.

The first question that you should be asking is why someone would loan out their share of stock. There’s always the risk that the person you lend it to won’t return it (which is called counterparty risk), and it just makes your life more difficult to have to keep track of where all of the shares you own are. The reason you would do it is that you’ll effectively charge a fee when someone wants to borrow a security from you. And this is actually very common. Passively managed funds do this all the time, and it can add up to a reasonably nice return boost (or a nice little profit for the fund company if they don’t give the money to the fund).

One other point to make here is that shorting a stock is riskier than simply owning that same stock. As the owner of that share of Company A the most you could possibly lose is the current value of the stock, and that would require the company to lose all of it’s value and go to $0. That’s pretty unlikely to happen. If nothing else, all of the computers and office equipment is worth something. On the other hand, the potential loss of a short position is infinite. The stock can just keep going up, and you can keep losing money – and this is going to be important in a minute.

In the case of GameStop, there were a number of people shorting the stock pretty heavily. By one estimate, 140% of the shares outstanding were being shorted. This is where the story starts getting a little bit more complicated.

First off, one of the regulatory changes after the Global Financial Crisis in 2008 was that you aren’t allowed to do a naked short of a stock anymore. A naked short is a short position where you don’t own the underlying stock or know that you can purchase it. You can see why this might raise some eyebrows when substantially more than 100% of the outstanding shares of a company are being shorted. That said, there are enough loopholes in the regulations that (so far) we don’t know of anyone (egregiously) breaking the rules, though that could obviously change. In other words, the shorts were being pretty aggressive, but were probably following the rules as written.

WallStreetBets

On the other side, we have Reddit. Specifically a subreddit (effectively a community within Reddit) called WallStreetBets. To set the stage, WallStreetBets describes itself as “Like 4chan found a Bloomberg terminal.” This is not a sober, rational minded investment group. These are folks who think about investing like, well, betting. And they back up their talk. Last week they noticed the heavy short positions in GameStop, and decided (for all sorts of reasons) that they disagreed with the folks taking the short position, and started buying up shares of GameStop.

The technical name for what they did is a “short squeeze.” This is why I told you to remember that a short position has the potential for unlimited losses. Because people were buying up GameStop, and pushing the price up, all of the shorts were losing money. The people pushing up the price were betting that they could push up the price so much that the shorts would break and unravel their short positions – which means all of those people coming to the market to buy even more of GameStop, pushing the price up even more.

And it actually worked. The price shot up like a rocket, and the shorts lost huge amounts of money. Melvin Capital, the hedge fund that has become the poster child of the shorts, reportedly lost 53% of it’s value in January.

But there’s a couple of things that are important to recognize here.

A short squeeze is a short term thing. GameStop is not “truly” worth almost three times what it was worth at the beginning of the year; it didn’t magically become a good company overnight. The price is going to come back to Earth. And we’ve already been seeing that, as it’s lost 89% of it’s value relative to the high over the past 5 trading days. There are going to be a lot of people who are going to lose a lot of money because of this. Most likely, the individual investors who jumped in after the initial squeeze. The people who are going to lose money are the people who heard about everything on the news and decided that they wanted to get in on the action as well. Those are the people who bought near the high and are going to be riding it all the way back down.

As much as the media would love for this to be a pure David vs Goliath story with some “virtuous” individual investors from Reddit doing battle with the evil hedge funds rooting for a company to go out of business, that’s not really what happened. WallStreetBets did play a part, and this is probably the biggest coordinated action we’ve ever seen from individual investors on something like this (which might cause some problems for them[link to other article]), but there were a lot of institutional investors on all sides of this fight. Hedge Funds as a group probably didn’t lose much (if any) money in this fight – the money just got shuffled around a bit. But that obviously doesn’t make a very good story.

Robinhood Giving to the Rich?

The other aspect that’s important to talk about is what happened with the retail brokers, exemplified by Robinhood. Robinhood is, or was, the favored broker of the WallStreetBets community because it offered commission free trading, as well as access to options and an easy to use app. Last week, when GameStop was at it’s height, Robinhood and a number of other brokers restricted trading on GameStop and a number of other stocks.

As you might imagine, this was wildly unpopular. People immediately starting filing lawsuits and accusing Robinhood and the other brokers of trying to protect Hedge Funds and other “Wall Street types.” To put it plainly, this is not true. To understand why, we need to talk a bit about how stocks settle – the actual process behind how you can buy and sell stocks.

Trade settlement is effectively the plumbing of the financial markets. Literally everything relies on trade settlement, but no one wants to think about it. It should just work. And it does almost all of the time. But seriously bad things happen when it starts breaking down. While people may be upset with Robinhood right now, this was an example of the system working, or at least preventing a more serious problem.

When you buy or sell a stock the transaction doesn’t happen immediately. Stocks use something called a t+2 settlement. Basically, this means that they actually settle – everything changes hands – two days after you buy or sell the stock. There are complicated reasons for this, but it’s basically a hold over from the pre-computer days. So when you buy or sell a stock on Robinhood, or through any other broker, the money is actually floating for a couple of days.

But the actual process of this settlement isn’t done by the brokers, it’s done by clearinghouses. The brokers pass on the trades that their clients make, and the clearinghouses are the ones who handle the process of getting the money and shares to the right people. To ensure that the people who are selling stock get their money, brokers need to post collateral (if you’re selling stocks the share you’re selling is it’s own collateral). The actual calculation for how much collateral a broker needs to keep with the clearinghouse is kind of complicated, but it’s trying to figure out how much the broker, who is the one on the hook if the client doesn’t actually have the money to pay for the stock, could owe if everything turned against them. And crucially this calculation assumes that the positions would net against each other – which is great if everyone isn’t buying the same stock.

You can see where this is going.

Because everyone was buying the same small group of stocks, Robinhood and other brokers needed to immediately post a lot more collateral with the clearinghouse, and they couldn’t come up with the money immediately. In Robinhood’s case, they were able to raise a bunch of money over the weekend to post as collateral with the clearinghouse to open up trading a little bit (editors note: as of Friday morning Robinhood has lifted their trading restrictions on GameStop).

This isn’t a case of Robinhood and the other brokers trying to protect the big guys, but rather a case where the markets are trying to make sure that things keep operating in a reasonable manner. It doesn’t mean that Robinhood’s clients are going to like it, though.

So What Happens Next?

Well, that’s the big question. Robinhood and the other brokers are likely to open up trading on Robinhood again, so it is possible that we will see GameStop et al get another pop, but it seems likely that this whole episode is winding down.

GameStop and the other affected stocks will probably settle back somewhere close to where they started out – nothing has meaningfully changed about their business, some people will have made some money, and a whole lot of people will have lost a bunch of money. We’ll also probably see investigations and some sort of regulatory response (attempted or otherwise). But overall, this is likely a flash in the pan. As I mentioned earlier, GameStop is only less than a percent of a percent of the total US stock market. If you didn’t actively get involved by trading in these companies during this whole process, you really didn’t have all that much exposure. For diversified investors it just won’t have much impact on whether you will be able to reach your goals or not.

But it does raise a number of questions about how the markets operate, how we should think about the markets going forward, and if people will be seriously talking about Stonks and Meme Stocks in the future. That said, they are talking about Silver next…

We get into some of these questions in our article What Does the GameStop Kerfuffle Mean?