Did you hear GameStop went viral?
Here’s a quick guide to the market frenzy you’re seeing in the headlines.
What is GameStop (GME) and why does everyone care?
GameStop is an actual brick-and-mortar video game chain that hit hard times in the pandemic. Like many distressed companies, it was targeted by short sellers betting that the stock’s price would go down.1
Basically, short sellers do the opposite of most investors. They try to make money when a stock’s price falls. They borrow shares from their brokerage for a fee, immediately sell them, and plan to buy them back later at a lower price when the price falls. Shorting is a risky strategy used by certain types of hedge funds.
What’s a short squeeze?
Shorting stocks is risky since any positive news or interest in a company can drive the stock’s price up. When short sellers bet wrong and a stock’s price rises, they can be forced to buy shares at higher prices to cover their losses (or pony up more collateral = CASH).
A squeeze happens when short sellers scramble to buy shares to cover their positions when the stock price is rising. The more investors who buy and hold those shares, the harder it is for short sellers to find shares to buy (exposing them to potentially huge losses).
With us so far?
Where does Reddit come in?
After it became clear that short sellers (mostly a few hedge funds) were betting on GameStop’s demise, the popular company became the focus of amateur traders on the popular WallStreetBets forum on Reddit, a popular community of chatrooms and forums.
By banding together and coordinating buying activity, these small-time traders boosted the stock’s price far above what the company’s financial fundamentals support, putting pressure on the hedge funds betting the other way (short)2.
The stock went viral.
Social media chatter + “free” trading apps like Robinhood + bull market + new investors with time on their hands = FRENZY
Is it illegal? That’s a stretch. These armchair traders are egging each other into speculative bets for their own gain and amusement, but we don’t think it rises to the level of illegal market manipulation. However, regulators might feel differently. That’s being debated right now.
Is it bad for markets? Maybe in the short term. The battle between gleeful amateurs pushing prices up and hedge funds scrambling to force prices down (selling short) has led to some of the highest volume trading days on record and cost short sellers billions3.
Is this David vs. Goliath?
We don’t think the GameStop bubble is just about greed or boredom or euphoria. We see a more powerful narrative at play.
We think a lot of these small traders are angry at the perception that All-Powerful Wall Street is pulling strings and using connections to hurt mom-and-pop (Main Street) investors. They see this as an opportunity to stick it to the big-money pros by using their own strategies against them.
It’s New school vs. Old school. The Rebels vs. the Empire. Bueller vs. Principal Rooney. Reddit vs. CNBC.
So, should I be investing in GameStop(GME)?
No. GameStop’s stock is massively inflated and trading has been halted multiple times because of its meteoric rise.4 At this point, it looks like folks are piling in just to say they were there, kind of like a financial Woodstock, but worse.
When the bubble bursts, it’ll be a rush to sell and many GameStop holders will probably end up losing most of their investment.
(It might already be happening by the time you read this.)
We’ve seen frenzies like this many times before. Tulip mania in the 1630s, the Nifty Fifty in the 1970s, the dot-coms in the 1990s, Bitcoin’s multiple bubbles over the last decade, etc. We’ll see more in the future.
Why are people angry at Robinhood?
Amidst the buying frenzy, Robinhood and other popular “free” brokerage platforms suddenly restricted trading on several red-hot stocks, including GameStop.5
Protests erupted from investors, many market pros (not the short sellers, obviously), lawmakers and more.
Did Robinhood halt trading to appease big investors at the expense of small investors? Did they do it to protect markets from manipulation and liquidity problems?
It depends on who you ask. These “free” trading apps spend millions on advertising, technology, and people. They must be getting paid somehow. They have investors (hedge funds, private equity) and they receive millions to send “trade data” on their retail clients to their “main” clients (hedge funds). Why would they do this you ask? These hedge funds want to know what stocks are being bought and sold. Sometimes they find out before the trades are actually executed. Does this seem like a conflict? Sure. Why would hedge funds want this information? Because much like we’ve seen this week, they may hold stock positions that directly conflict with the retail (Main Street) clients of the “free” trading apps.
We dislike the idea that a broker can just shut down trading in a security. We think it opens the door to situations where platforms prioritize one investor (large vs. small) over another and that’s a massive conflict of interest.
We have been fielding a ton of calls, texts, and emails this week from people all over and we’re frustrated on behalf of everyone else affected by brokerage outages and difficulty trading. Luckily, and by design, our clients are not experiencing any of this.
Frankly, it’s pretty wild that a bunch of regular folks with small trading accounts can bring massive institutional investors like hedge funds to their knees.
What are the implications of this frenzy?
There’s no predicting the future, obviously, but we think a few things are likely. Most bubbles end naturally when the euphoria turns to panic, folks start selling, and the price crashes. However, it’s also possible that regulators will step in if they think there’s real risk to markets (or they see too many investors getting hurt).
We think this ride’s going to end in tears for many folks caught up in it. But we’re not sure who will be crying hardest.
We do think markets could see some wild swings and pull back from their frothy highs, but don’t see major risk. Yet.
But, we think we’ll be left with some pressing questions once the dust settles. Will social media traders continue to drive big market moves? Do platforms have the right to arbitrarily decide customers can’t trade? Are coordinated moves by small investors a danger to markets? Should regulators be watching hedge funds more closely? This is an evolving situation so we’re keeping a close eye on markets to see what might happen next.
Questions? Thoughts? Please contact us and let us know.
RINA Wealth Management Services
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This content does not constitute accounting, tax, investment or legal advice, nor is it intended to convey a thorough treatment of the subject matter.