If you follow the financial markets, the GameStop story felt like watching the Super Bowl. A number of individual traders, sharing research and stock picks on the Reddit forum WallStreetBets and trading from their phones, managed to beat hedge fund managers at their own game, inflicting billions of dollars in losses.
How did this happen? To explain the GameStop saga, it is important to understand what “short selling” is. If you own a stock and you expect its price to fall in the future, you can sell it. If you don’t own the stock, but expect its price to fall, you can “short” it or “short sell” it. Short selling involves borrowing stocks for a specific period of time, selling them and buying them back to return them, preferably once the price has fallen down.
This is what some hedge fund managers were hoping to do with GameStop. Hedge funds are investment firms that specialize in risky investment and trading strategies, including short selling, to generate high returns. Like many storefront retailers, GameStop has seen declining profitability and intense competition from online streaming. The stock seemed like an easy short selling target.
Free time due to COVID-19 lockdowns along with access to information and analysis tools and a desire to make money enabled WallStreetBets to identify the GameStop short positions. Going against the hedge funds positions, the group bought GameStop driving the stock’s price higher. It is not clear why WallstreetBets chose to buy GameStop. Did they truly believe that GameStop is worth investing in? Did they buy in order to save GameStop from the shorts? Since WallStreetBets is dominated by millennials and Gen Z who grew up shopping there, did nostalgia play a role?
As the stock price increased, the hedge funds were forced to buy back the stock. They bought in high volumes, which increased the price even more. The stock moved from about $18 in early January to $483 on January 28th. The WallStreetBets traders squeezed (took out) the shorts (the hedge funds) out of the trade. This is referred to as a “Short Squeeze”. This caused many of the WallStreetBets traders to make a fortune and inflicted huge losses on the hedge funds.
This story demonstrates how technology has changed Wall Street. The individual investor has access to information, research and analysis tools and commission free trading. Social media also plays a major role in allowing individual traders to communicate, coordinate trades, and impact stock prices. This highlights the emergence of the individual investor as an important player in the financial markets.
With increased access to the stock market, education is ever more important. The stock market remains the best mechanism to invest and generate wealth. More participation is certainly desirable as it allows people from diverse backgrounds to achieve economic prosperity. However, the market is also risky. Investing all of your money in one or a few stocks is dangerous because you could lose everything. Timing the market by trying to figure out future movements is very difficult, even for the professionals. This is why diversification and long term investment is important. You can achieve it by buying cheap index funds, as they allow exposure to the market at lower risk. Your risk is spread out as your money is invested in a large number of stocks instead of one or a few stocks.
The WallStreetBets traders that bought the stock at a low price and sold at a high price due to the “short squeeze” made money. The rest of the traders who refused to sell to “send a message to the establishment” got emotionally involved with the trade and are likely to see their profits go down as the price of the stock falls. The rest of traders that bought the stock after hearing of the GameStop saga in the news and before trading got restricted, paid a high price and are likely to sell at a low price as the stock closed at $53.50 on Friday Feb 5th. Nevertheless, participation in the stock market is important, but diversification is better than stock picking and time in the market is better than timing the market.
Dr. Nadia Nafar is Assistant Professor of Management, Business and Economics at Virginia Wesleyan University. She conducts research on Investments and Corporate Finance and teaches Finance at the graduate and undergraduate level.
Dr. Nadia Nafar