It’s not very often that a story about a hedge fund making a small bet against a thinly traded stock would become the biggest news story in the world, but we live in a new world where Reddit, Robinhood and Gamestop have dominated the news cycles over the last week. So what in the heck happened? There are a lot of moving parts and a lot of terminology most people outside of the investment world aren’t familiar with that make this story seem much more complicated than it really is. Here are 10 questions I’ve been hearing and seeing, and some plain language answers as to what it all means.
Question 1: What is a Short Sale?
Many articles have made mention of hedge funds (specifically Melvin Capital in this case) being “Short” Gamestop. In the most basic terms, this just means they have made a bet that the stock price will drop. Mechanically this means that they “borrow” the shares and then sell them. If the price goes down, they can repurchase the shares at this lower price, return the borrowed shares, and pocket the profit. Let’s look at a hypothetical example. A hedge fund sees that Gamestop is trading at $20/share. They think the actual value is less than this and the price will eventually drop, so they want to bet against it and decide to “short” the stock. To do this, they will call up big institutional funds (ex. Vanguard) and ask to borrow the shares. In this example, if they want to short $1 Million, Vanguard will lend them the 50,000 shares for a small fee, and the hedge will fund will immediately sell the shares on the open market for $1,000,000. If they are correct and the price drops from $20/share to $10/share, the hedge fund will then buy back the 50,000 shares @ $10/share for $500,000, return the shares to Vanguard, and pocket the $500,000 (minus the fees). The risk is obviously that the price goes up. In the scenario where the price rises from $20 to $30, the hedge fund will need to come up with an additional $500,000 to buy back the shares, and thus take a $500K loss on the transaction.
Question 2: How can they sell something they don’t own? Isn’t that unethical?
This question has been making its rounds, and Elon Musk even tweeted something to this effect. The fact is that there is nothing nefarious about shorting stocks, and it has been a part of stock trading for as long as the stock market has existed. The goal for any marketplace is to efficiently set prices so that a consumer can trust they are getting a “fair” price on a purchase. If a loaf of bread cost $1 at one grocery store and $10 at another, the marketplace for bread would be distorted and untrustworthy. The greater the information and number of participants, the more efficient the price of a good or service. This is no different in the stock market. Using our Gamestop example, if information was available that indicated the stock was undervalued, it is simple for any participant to just purchase this stock to bet on it going up. However, if information was available that showed the stock was overvalued, the current holders of Gamestop would be the only participants with the ability to act on this information by selling their shares, unless there was a mechanism such as short-selling. Obviously the universe of Gamestop shareholders is far less than the overall universe of investors, so the allowance of of short selling greatly increases price discovery and leads to a much more efficient market.
Question 3: What is a short-squeeze?
This is where things get interesting. In most normal occurrences, a hedge fund shorting a stock would have no bearing on the rest of the market participants who are just buying and selling that stock based on their own expectation of what the stock is worth. However, in rare instances, it becomes known that one fund has a large short position, so some other party (generally another hedge fund) will buy a bunch of shares to drive up the price, which will cause the short position to lose a whole bunch of money. This takes a coordinated operation with a whole lot of money to “squeeze” the short position, and so is therefore rarely seen.
Question 4: Why is this time different?
To execute a short squeeze, two things are required: Ability and money. In the past, it was only other big institutional investors who could execute this. Enter Reddit and Robinhood. Until recently, individual investors didn’t have the ability to easily buy and sell stocks, and if they did, the transactional costs were too high to really trade at high volumes. Robinhood flipped this idea on its head by offering free trading of stocks even in small amounts. All of a sudden, individual investors have the same ability as the professional institutional traders…but they didn’t have enough money to make any meaningful moves in the market. This is where Reddit comes in. Reddit is just an online forum where people can discuss ideas in any different category. A specific forum within Reddit called wallstreetbets has garnered an enormous following to discuss ideas for stock trading. A few users realized that Gamestop had a large amount of short bets, and rallied support among their hundreds of thousands of followers to band together to buy shares and drive up the price. While none of them individually had anywhere near the money of an institutional fund to move the market, together they did. Here is a chart of the short % and stock price of GME thru the end of last week:
Question 5: What does this mean for Gamestop as a company?
There is a common misconception that purchasing a stock is investing in a company by providing it capital. This may be true for an early-stage private company, but once a company goes public and sells off the vast majority of its shares, the ups and downs of the stock price are only affecting those trading the shares in the secondary market. The market cap (shares * price/share) of Gamestop going from < $1B to > $20B in just a few weeks does not generate any profit or additional capital for Gamestop itself. The notion that Redditors “saved Gamestop” is not accurate.
Question 6: Why did brokerages restrict trading? Was this unethical or even illegal?
Robinhood became enemy #1 for everyone from Dave Portnoy to AOC to Ted Cruz. Right in the midst of the huge run-up in price, they restricted users from purchasing shares of Gamestop along with several other stocks with similar unusually high volume. Pairing this with Discord shutting down the Reddit forum for supposedly unrelated issues, and conspiracy theories abounded. Robinhood’s official explanation was that they didn’t couldn’t meet the capital requirements needed to execute the volume of trades that were coming through, and there certainly may be some truth to that, but many industry insiders think there may be more to the story. While I’m not in a position to speculate, the confluence and timing of events doesn’t pass the sniff test.
**An important caveat here is the restricting of stock purchases by Robinhood compared to some restrictions by other large institutions (TD Ameritrade, Schwab etc.) that shared some headlines. TD and Schwab increased margin requirements and restricted short-selling on some of these stocks with irregular liquidity, which is a very common practice to safeguard investors.
Question 7: Is there a historical precedent?
Not exactly, but it’s not entirely novel either. The idea of artificially pumping up the price of a stock to make a profit is not new; it was highlighted in the “pump and dump” schemes popularized by the movies “Boiler Room” and “Wolf of Wall Street”. In those scenarios, the brokers would buy a cheap stock and then convince as many main street investors as they could to buy the stock, thus driving the price higher. Once the price peaked on the new demand, the broker would then dump the stock, and pocket a nice profit. The difference here is that it’s a group of redditors driving the price up, and the victim is a Wall Street hedge fund, but the general idea is the same.
Additionally, we have seen short squeezes in the past lead to a skyrocketing price for a short time. Volkswagen stock back in 2008 was probably the most famous of these occurrences in recent years, jumping from $28/share to $109 share in under a week (followed by an equally impressive drop). But again, the players involved were Wall Street insider institutional traders, so still a very different scenario.
Question 8: Does this undermine market efficiency?
The short answer is no. However, if one is defining an efficient market as the current price of any stock being the best estimate of its intrinsic value, then it would difficult to reconcile what we have witnessed over the last few weeks. The longer answer is that while over the long term and over the broad market, efficiency prevails and stocks are generally fairly priced, there are times where speculation trumps prudent investing and bubbles are created. This is explained by an idea called “The Greater Fools Theory”. This is the idea that someone will purchase something not because they think it’s a good value, but because they think they can sell it to someone else for a higher price in the future. Bubbles and pyramid schemes are two sides of the same coin; you can make money as long as you’re closer to the beginner than the end. As long as you can find the “greater fool” willing to pay more than you paid, you will be fine. The problem is eventually that theory runs dry, and there are a lot more people at the base of that pyramid holding the bag of overpriced assets than there are early investors that made all the profit. We have seen bubbles arise for as long as there have been markets. In fact, back in 1720 Isaac Newton, who many believe to be one of the smartest people to ever live, got swept up in such a bubble. The hottest stock of the day was the South Sea Company which saw a meteoric 10x rise in price and subsequent equivalent crash within about a year. Newton got in near the top, and lost the equivalent of $3M in today’s dollars. His famous quote recounting the ordeal was “I could calculate the motions of the heavenly bodies, but not the madness of the people”. The commonality in all bubbles is that they eventually pop, and the price of the asset resets to a value in line with the fundamentals. For those that choose to invest prudently and ignore speculative trading, these are nothing more than blips to be ignored.
Question 9: Is this the new norm? Should I take advantage?
The answer again is no. While this situation was unique and interesting where main street nobodies were able to take advantage of the Wall Street behemoths, that opportunity is probably now closed. What will follow will be artificially created bubbles at the nudging of the Reddit community that will turn out just like every other bubble in which many more people lose than win. We’ve already seen this, with Silver being the next big thing pushed on Reddit, leading to the price per oz. going from $25 to $30 (20% gain) over a 3-day period, followed by it dropping back to $26 the following day.
Question 10: Did this saga impact the overall market or my portfolio?
It’s easy to think that because of the headlines that the market was shaken to its core of the last week. Headlines read “Billions were made and lost” and talked about new paradigms, so an obvious conclusion would be that the entire investing universe was impacted. However, this was not the case. While the volume in Gamestop was thru the roof, it was still just a drop in the hat relative to the overall market, which often sees over $1 Trillion in trading volume in a single day. In the chart below, as Gamestop shot up and down like crazy, market indices barely moved and were relatively flat over the whole time period. Unless you were speculating on individual stocks, your portfolio wouldn’t have even felt a tremor. As with many things, it’s easy to confuse a fun story with a useful narrative.
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