Explained: The GameStop Stock-Trading Frenzy
The unprecedented, meteoric rise of GameStop’s shares at a time when Wall Street bet on its steady decline can be attributed to, above everything else, social media.
GameStop. Whether or not one harbours an interest in the American stock market, it is unlikely to not have come across this video-game retailer’s name in the last couple of days. The unprecedented, meteoric rise of GameStop’s shares at a time when Wall Street bet on its steady decline can be attributed to, above everything else, social media. What started as harmless memes on Reddit’s r/wallstreetbets forum soon escalated to maniacal mass buying of GameStop and other unexpected shares, propelling successful hedge funds into colossal losses.
Fascinatingly enough, GameStop itself had little to do with it.
Wait, what’s going on with the Wall Street hedge-funds?
Okay, let’s start from the very beginning. Wall Street hedge funds like Melvin Capital and Citron Capital ‘shorted’ the GameStop Corp (GME) stock, betting its prices will fall enough for them to pocket a massive profit. ‘Shorting’ implies loaning shares from a broker in order to sell them; anticipating that the price of that stock will go down, which is when they would buy the shares back at a lower price and return them to the broker. The difference between their selling price and the price at which they repurchase the shares results in a profit or a loss, depending on whether the stock prices go up or down. The cardinal rule in shorting a stock is that you absolutely must buy the shares back after selling them, irrespective of the profit or loss margin. Short-sellers thus theoretically are set up for infinite losses, because although on the lower end, stock prices cannot go below 0, there’s no limit to how much it can rise. This is what makes ‘shorting’ so risky— you’re essentially selling something you do not own and will have to buy back, no matter how its price changes.
So if that’s a short, what’s a short squeeze?
A bit of a double whammy actually. So when short-sellers start buying back the shares they borrowed, at a price higher than the one they sold them at, they further drive up the price of the given stock. This results in what is known as the ‘short squeeze’.
How are Redditors involved here?
Now, this is where things get interesting. The retail investors on Reddit’s Wall Street Bets forum caught on to Melvin Capital shorting stocks like GameStop around late October last year. Almost jokingly, the amateur day traders in the Reddit group started drumming up a colossal hype around GameStop, aggressively buying shares and driving up its price, as short-sellers reeled in losses they never imagined. Enter Elon Musk, who posted Wall Street Bet’s Reddit link on his Twitter on January 27. According to CNN, after his tweet, the stock crossed $200.
Not only shares, investors who decided to ride the GameStop wave also started trading options, equivalent to placing a bet in opposition to short-sellers. Similar to how short-sellers bet on a stock price going down, options traders count on stock prices going up in order to earn a profit. This is what options traders do: they purchase a contract to buy a given stock later at a predecided price; so if the price of the stock exceeds that, they can purchase it at the agreed-upon lower price and sell it with a profit margin. It’s like locking your price for a stock beforehand. If the price goes up, profit is guaranteed.
Both stock trading and options trading favoured the meteoric rise of GameStop shares and drove Wall Street’s short-sellers into losses worth billions of dollars.
What’s Robinhood and what do they have to do with all this?
Robinhood is a free stock-trading application that allows individuals to trade stocks, cryptocurrencies, options, ETFs, and ADRs without having to pay exorbitant commissions for brokerage. Co-founded by Indian-American Baiju Bhatt, Robinhood boasts of 13 million users, as of 2020. Their website carries a bold pledge: ‘to democratize finance for all’. When GameStop’s stock prices soared, amateur traders flocked to apps like Robinhood to jump into the Wall Street Bets bandwagon.
On Thursday, amid this unprecedented stock-trading frenzy, Robinhood imposed temporary restrictions on the purchase of stocks like GameStop, AMC Entertainment, Blackberry, and Nokia— all of which were at the receiving end of this social-media-driven investing hype — citing reasons of ‘recent volatility’. The results of this move were immediate. GameStop’s shares slid by at least 44% that very day, while the other restricted stocks also took a hit. Interestingly enough, although the purchase of these stocks was banned, selling them was not.
Obviously, this did not sit well with retail investors. Many started alleging that Robinhood’s decision was to alleviate the condition of the Wall Street speculators who lost their money on their failed short-selling attempt. US Congresswoman Alexandria Ocasio-Cortez tweeted that Robinhood’s decision is ‘unacceptable’, garnering support from the likes of Elon Musk and Republican Ted Cruz.
The trading app was also slapped with a class-action lawsuit on Thursday, for allegedly stripping its users from freely using their services in order to “manipulate the market for the benefit of people and financial intuitions”.
What happens next?
Matters of the stock market are hard to predict, but according to The New York Times, Robinhood gave in to the backlash and announced that they would allow “limited buys of these securities” on its platform on Friday.