In last week’s what we’re watching section, we briefly mentioned the developing GameStop vs. a hedge fund story.
Many other people watched it, too (although the hype didn’t really take off until after we published. Coincidence?).
Since then, the story went to the moon, with the financial world’s attention absolutely fixated on it.
Here’s what you need to know.
One week in 398 words
Late last year, a community of retail stock traders mostly organized around the subreddit Wall Street Bets (WSB) started buying GameStop stocks and call options (the right to buy stocks at a certain price), largely using the zero-cost trading app Robinhood.
GameStop is an American video game brick-and-mortar retailer.
Some hedge funds, notably Citron Capital and Melvin Capital Management, made enormous bets against GameStop, believing that they have an outdated business model.
The traders on WSB decided to stick to the hedge funds and put a “squeeze” on their short positions (more on that below).
By the end of the week, the situation spun out of control.
Both hedge funds took massive losses.
Meanwhile, Retail trading platforms, including Robinhood, had to suspend purchases of GameStop shares.
At first glance, it looked like they did this to appease the hedge funds since these giants could still trade the stock.
As it turns out, the real reason for the suspension was due to operational risk factors.
In brief, whenever you buy or sell a stock, it takes three days for the trade to “settle” or for all the paperwork to finish making it final.
With demand literally skyrocketing, cash wasn’t fast enough to reach the trading platforms to ensure that settlement would happen.
The banks that actually process the trades didn’t want to take the risk and instead asked their clients to take action, in this case, Robinhood.
Yet, despite the rational reasons for Robinhood and others to stop trading, the public perception of their actions on the “David vs. Goliath” narrative was too strong.
By the end of the week, there was an outcry from all corners of the political universe, including progressive Alexandria Ocasio-Cortez, conservative firebrand Ted Cruz, and…Donald Trump Jr.
Who knew that a small video game retailer would bridge the vast American partisan divide?
The Securities and Exchange Commission who is the US markets regulator, pledged to investigate the situation.
Robinhood’s clients are now suing the platform for suspending trades.
Financial news outlets couldn’t shut up about it (yeah, I see the irony in writing about it as our feature. However, we were into it before it was cool. If that makes us economic news hipsters, so be it).
What a week…
What’s a “short?”
Let’s quickly go over a short trade or short selling.
A short trade is a bet against the price of a stock.
While most investors want their stocks to rise in value, short investors want them to drop, believing that others overvalue the underlying company.
A short position works like this:
- Let’s say that a short-seller thinks that Apple is overvalued and their next iPhone will be a flop
- This investor wants to put their money where their mouth is and borrows Apple shares from a broker.
- The broker asks the short-seller to deposit cash or other stocks in a ‘margin account.’ This deposit acts as “insurance” or collateral for the broker in case the bet goes bad
- The short-seller immediately sells their borrowed Apple shares on the market. Since most investors think Apple will go up, he has no problem finding a buyer.
- Now, he waits for the iPhone’s release, its sales to disappoint, and the share price to fall.
- When the price falls, he buys shares from other investors, which should be at a lower price than for what he borrowed them.
- With the new Apple shares in hand, he returns them to the broker.
- The difference between what he borrowed the Apple shares for and what he paid for them, later on, is his profit.
So far, so good.
But what happens if the share price goes up?
- So let’s say that people love the new iPhone. Its sales outperform, and Apple’s share price rises.
- Suddenly, the short-seller is losing money since he’ll pay more for the shares on the market than for what he borrowed.
- As the price rises, his losses mount, in what we call a “short squeeze.” Since share prices have no upper limit, his risk is unlimited.
- Meanwhile, the broker keeps asking him to deposit more cash or collateral to offset the risk they took for lending him shares.
- Eventually, he buys the shares for more than he borrowed, returns them to the broker, and takes a loss. The more the share price goes up, the bigger his loss.
There’s a bit more to it, but that’s the general idea behind short selling.
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What does the GameStop saga mean for the markets & investing
There’s a lot to unpack, but here are our main takeaways.
The technological rise of “swarm trading”
While building over the past few years, “swarm” trading like we witnessed is here and is probably not going anywhere.
First, trading costs don’t exist anymore (at least in the US), which removes psychological and financial barriers to making these sorts of bets.
More importantly, the community factors that control the swarm are bigger than ever.
While online forums for investing & trading existed well before 2020, the pandemic pushed them front and center as our social circles went virtual.
These connections will be hard to break, especially when the community also represents a social cause.
Throw in frictionless trading and people willing to put their money where their posts are, and this trend will be around for the long term.
What about the shorts?
Some big hedge funds got burned by taking sizeable short positions and, oddly, not hedging them (go figure).
This whole fiasco resurrects the old question: Shouldn’t betting against a company be illegal?
On the surface, that argument seems fair.
After all, if the whole idea of a share or a market is for it to grow (and bring the economy up with it), hoping that a company fails is counterproductive.
Yet, shorts play a crucial role in our economy.
Betting against a stock effectively gives investors a way to call bullshit on a company or trend.
This accountability cools off bubbles, keeps companies honest, and provides dissenting strategies against the herd or swarm.
The story revolves around the build-up to the 2008 financial crisis and a couple of contrarian investors.
It puts the mentality and purpose of short-sellers into perspective.
Diversification still wins
Diversification is still the key to long-term success.
Yes GameStop, was the undoubted “market winner” last week (up 400% at one point ← rocket ship).
Yet, winners and losers cycle in and out of the market all the time.
While some traders made a lot of money on GameStop, they took an enormous amount of risk.
They did so almost purely on emotional thought.
Over the long run, that’s not a sustainable or even a wise strategy, especially since we’re likely in a bubble.
Bubbles are notorious for badly burning retail traders.
There are all too many stories right now of people selling their retirement funds and dumping all of their savings into GameStop (kind of like what people did with Bitcoin in 2017).
I truly hope they can get out on top. Remember that once someone starts selling, others follow, quickly driving down prices.
The only protection against a bubble is to spread your investments with diversification (which a financial adviser can help you with #ContentMarketing).
The week that got everyone’s attention
If anything else, the GameStop saga has been entertaining to watch.
It also gave us economics newsletter guys stuff to write about.
In the end, though, it’s but another chapter in the evolution of markets and investing.
As much as things appear to change, the laws of economics stay the same.
Until then, pop the popcorn, enjoy the memes, and, you know, “share this newsletter.”