This past week has seen yet another unprecedented phenomenon in the capital markets – the saga of GameStop and other companies whose stock prices have gyrated wildly.
Although some things are new in this development, some are not. Furthermore, many evolutionary market trends that have been going on for many years have contributed to this amazingly volatile story. Finally, it is important to distinguish that the players in this “game” are traders, not long-term investors.
GameStop is a small, money-losing company. Its business is selling computer and video games in small stores, predominantly in malls. It has struggled in a dynamically changing technology and retail environment where an increasing number of “gamers” are now downloading games from the Internet rather than buying them at a store. The company is also saddled with debt.
Due to its very poor operating performance and deteriorating financial performance, the stock has languished for years. Many sophisticated hedge funds that recognized this challenging fundamental situation collectively sold a significant amount of the outstanding stock “short.” In a short sale, a trader essentially must first borrow a company’s stock from existing shareholders before selling it. In doing so, the trader is obligated to abide by margin rules that the brokerage industry has established. These rules require that, if contrary to the trader’s bet, the stock starts going up, the trader is required to either buy back and return the borrowed stock or post cash collateral to maintain their short position.
Although hedge funds had established what seemed to be a rational short position in GameStop, as well as other companies experiencing challenges, some individual traders found a few kernels of potentially positive news and began buying shares in these deeply distressed stocks.
They also noted, through required public disclosure, that there was a growing level of “short interest” in these stocks. This information, along with the knowledge that traders who had sold stocks short would be required to buy back the stocks if prices started trending sharply higher, helped generate further interest in these stocks.
Individual traders then used the exponential communication power of social network platforms to broadcast their intentions and solicit new followers, thus garnering what was effectively a “flash virtual mob.” An astounding number of individual traders then began aggressively buying stock in these distressed companies.
Although this sounds like it was coordinated, it most likely began as a loose confederation of intentional retail traders attracted to a speculative play that led to a multitude of other trend followers, many of whom had little knowledge of the situation except that the stock was vaulting higher. From a fundamental perspective the buying seemed entirely irrational. However, from a technical perspective it was rational – it was a classic “short squeeze”.
What is new about this case?
This is the first significant circumstance where the intersection of social media and the securities markets led to such dramatic losses for some institutional traders, while generating incredible profits for some small individual traders (although many individuals probably also suffered losses). The press has reported this as a compelling story of David vs. Goliath, with small traders “slaying” the fearsome institutional hedge fund traders.
Indeed, this is somewhat accurate. A few notable hedge funds were blindsided by this development and suffered damaging losses. These hedge funds had established rational short positions (betting a stock would fall) in the stocks of companies whose prospects looked very dim. They were unprepared for what would be considered the “irrational” behavior of the “flash virtual mob” whereby individual traders were buying just to “play the game” or to be part of a movement to inflict financial damage to “sophisticated financial insiders” – aka hedge funds and other institutional traders.