The GameStop saga

Last week, out of nowhere, “GameStop” was suddenly on everyone’s lips, taking center stage in media discourse and political rhetoric. As elected officials and Wall Street analysts staked out positions and demanded immediate action, many Americans were asking, “What is this GameStop business?”

To give the simplest answer to that question: GameStop is a video game retailer founded in 1984 and headquartered in a Dallas suburb. The company enjoyed a heyday between 2004 and 2016, growing to more than 5,000 stores around the world. It then went into decline when video games shifted to online sales.

GameStop’s plummeting stock price became the subject of a great deal of Wall Street speculation. And this is what led to last week’s uproar. Essentially, a significant number of establishment investors wagered that GameStop’s stock would drop even further — a common strategy called “short selling,” or “shorting” (for short). In the case of GameStop’s stock last week, however, this common strategy was undone by others who had carefully crafted a plan.

The plan was so audacious that its success hinged on a perfect correlation of factors. But this was of little concern to the small group of social media users who began plotting nearly two years ago to accomplish what no lone small-time investor could before. They congregated on the Reddit social media platform, which bills itself as “the front page of the Internet.” The group even attracted members who wanted to bring down the entire Wall Street system.

It didn’t take more than a few minutes last week. By the time it was over, they had burst into headlines around the globe, with governments vowing investigations, brokerages halting trading, investors venting pent-up anger, and millions of people wondering where this was all leading to.

A Perfect Storm

So what exactly happened? Let’s take a deep dive into the fascinating world of short squeeze, options buying, and margin accounts. Along the way we’ll meet heroes and villains, politicians, populists, and greedy investors.

I spoke to Shaul Hirsch, who is currently in a PhD finance program and for the past few months has been one of the only people in the world studying the effects of Reddit groups on the stock market, according to a program advisor.

“All the conspiracy people and anti–Wall Street people just piled on in the last week, after it all exploded,” Hirsch says.

Reddit’s social media app differs from others in that it categorizes chats into subgroups called Sub-Reddits. One of these special-interest Sub-Reddits is called WallStreetBets, launched in 2012 and boasting 6.2 million users.

The WallStreetBets plotters’ plan was simple — pounce on a company, drive its stock price sky-high, and then cash in by selling the shares. It had to be a company in that sweet Cinderella spot — not so small where pumping up the price couldn’t build a sustainable momentum, but not so large as to require massive investments to make a difference.

“You have to have the perfect storm of circumstances,” Hirsch says.

The companies they chose all had similar characteristics — companies of medium market capitalization that were already heavily shorted. They include AMC Entertainment, American Airlines, BlackBerry, Nokia, and Bed, Bath and Beyond. But the one that garnered the most attention was GameStop.

The current market roil began in the spring of 2019, when Keith Gill, a 34-year-old former financial advisor whose Reddit user name is “Roaring Kitty,” posted a picture of an investment he made: $53,000 worth of GameStop stock. Over the next year he posted incessantly on Reddit, Twitter, and his YouTube channel about his investment, drawing a throng of young people along for the ride.

If $53,000 was the “before” picture, Gill posted the “after” picture last Tuesday: He had turned a five-figure investment in GameStop into a value of $48 million. Within minutes, GameStop shares, which traded at $17 weeks before, began soaring. By Friday it closed at $325, a 1,625 percent jump.

“Your example has literally changed the lives of thousands of ordinary normal people,” a Reddit user named reality_czech posted to Gill. “Seriously thank you.”

Hundreds of others also earned quite a buck. “I’m a family man,” Issac Mooring, a college football coach, told the Los Angeles Times. “I have a personal interest to make as much as I can to build my family’s future.”

Latecomers to the game, such as community organizer John Motter, said their goal “isn’t to get rich on this, my goal is to bankrupt these billionaires.”

Coming Up Short

How did a group of small-time players, known in the industry as retail investors, accomplish this?

They did this by taking advantage of two rules set by the Federal Reserve Board and an internal industry regulator — that investors who short a stock must leave some money in an account as collateral, and that market makers who sell options to traders must have a certain number of stocks handy in case the traders execute those options and purchase the stock.

Sounds Greek? Here’s a tour through the market exchange.

The traditional investment strategy, as people think of it, is called “going long.” Let’s say a trader buys a stock at $15 a share, hoping the price will go up. When the share price reaches $30, he may sell the stock, pocketing a $15 profit per share.

The opposite strategy is called “shorting.” This is when a trader bets that a stock’s price will go down, not up. He does this by borrowing a share — usually from a brokerage that believes the price will stay the same or even rise — and then turns around and sells it to someone else who also hopes it will rise. The trader is still on the hook for the stock he borrowed from the lending brokerage. To repay the loan, he must purchase the same amount of stock he borrowed. He’s counting on the stock going down in value in the meantime, so he can repay the lender with lower-priced shares, thereby realizing a profit from his sale of the borrowed stock.

As an example, let’s say Tim Trader wants to short GameStop stock. It’s selling for $20 a share, but Tim is betting it will drop to $10 a share. He borrows ten shares of GameStop stock from Bullish Brokerage House, and turns around and sells the borrowed stock to another trader for the market price, $200. If Tim is right, and the GameStop stock drops to $10 a share, then he must buy ten shares at that price — that is, $100 — and return them to Bullish Brokerage. Tim is left with a $100 profit.

This strategy has led to some practices that have been declared illegal. One such practice is “short and distort,” which is when investors short a stock and then artificially distort its price by spreading negative information about the company, or convincing a large number of investors to sell their stocks. Another illegal practice, “pump and dump,” works the opposite way — investors buy stocks, then pump up the price using false information before dumping it on the market at a higher price than they originally purchased it.

Even the traders who short stocks legally have come under heavy criticism; they have been accused of taking a predatory approach toward struggling companies, hastening their eventual downfall while profiting handsomely.

The Short Squeeze

All this brings us to the “short squeeze,” which was the end goal of the Reddit WallStreetBets traders.

Under the law, a short seller must maintain a certain percentage of the share’s value in a margin account held by the stockbroker. This margin account is a form of collateral that guarantees the trader will have the money to buy the stock to return to the lender when the time comes. The required collateral depends on circumstances and ranges between 25 percent and 50 percent.

So, going back to our example, if Tim Trader wanted to short 1,000 shares of a stock currently worth $100 a share — totaling $100,000 — he would have to put $50,000 away in a margin account set up by Bullish Brokerage. If the stock goes down to $80 a share, for a total of $80,000, Tim now only has to keep $40,000 in the margin account, and can remove $10,000.

But what if instead of going down, the stock price goes up? What happens to Tim Trader? If the stock price rises to $120 a share — and listen carefully here, because this is the Reddit guys’ tack — his stock value is now $120,000, and Tim must accordingly boost the margin account to $60,000. He must also buy the stock at the higher price to pay back his loan from Bullish. In short, Tim has lost money.

Most hedge funds shorting a stock usually do not bother holding on when the price increases so dramatically, and just end their short position. They purchase the stock at the higher price to return to the lender and swallow their losses.

But when you have a stock that many traders want to short, and prices go up instead of down, those traders are suddenly rushing to buy that stock at the higher price — before it goes up even more. And in the formulaic world of supply and demand, that increased demand boosts the stock’s price even higher.

The traders who find themselves in such a position get “squeezed” between having to purchase the stock and the market raising that stock’s price. This is what a “short squeeze” is.

And this is what the Reddit plotters wanted. They looked for companies that had high “short interest” — that is, a high number of shares that had been borrowed by traders seeking to sell short, but that the traders had not yet repaid by purchasing stock. The Redditers took GameStop stock, which was already heavily shorted, and purchased tens of millions of dollars worth of its shares, boosting its price. Hedge funds who had shorted GameStop were then forced to rush to buy its stock and cut their losses, further increasing its value.

“In general, historically speaking,” Shaul Hirsch says, “most stocks out there have a short interest that’s very, very low. It’s rare for a stock to have a short interest over 10 percent. When you have a stock with a short interest above 20 percent, it usually means that it’s at risk of a short squeeze.

“For a stock to have a short interest above 30 percent — I don’t think there’s ever more than maybe 40 or 50 companies in the entire US stock market to have above 40 or 50 percent. The one stock that is getting all this attention, GameStop, had a short interest of over 100 percent. Meaning, this stock was particularly prone to a short squeeze.”

In effect, the Redditers were taking advantage of the short sellers of these companies’ stocks. There was nothing to suggest that companies such as GameStop, Blackberry, or Nokia should rise in value, especially since they were so heavily shorted. The exponential price hike made investors fearful of where this was going to happen next.

The Gamma Squeeze

The Reddit traders also used the latest technology to buy their stocks — the Robinhood and Ameritrade apps. Buying or selling stocks used to cost a mint, leaving it exclusively to the big boys to make money on the market. With the advent of the Internet, these fees began coming down, until Robinhood was founded eight years ago with the promise of free trading.

But there’s more. Many of the plotters took advantage of something called “call option,” which allowed them to manipulate the stock price’s rise.

Buying options is like going into a store and purchasing ten cases of eggs for the full price, and paying a small additional amount to reserve the option of buying ninety cases more. Investors, too, will sometimes reserve options on a bloc of stocks, paying pennies on the dollar to companies called “market makers.”

The vast majority of these options are never realized since they don’t reach the price where it makes sense to buy the stock. But in the meantime, the market makers must hedge their shares in case investors execute their options, so they purchase a certain number of the stocks to keep on hand.

The savvy Reddit users leveraged this mechanism to their benefit; they purchased huge number of options in GameStop, forcing the market makers to purchase large numbers of those stocks to keep on hand. Economics 101 then went into full gear, further hiking the price. This maneuver, of forcing market makers to buy stocks already shooting up in price, is called the “gamma squeeze.”

What resulted was the perfect storm Hirsch describes. And the way Wall Street reacted led to the worst anti–Wall Street vitriol in a decade. In an attempt to protect market makers from the gamma squeeze, and stock brokerages from the short squeeze, trading apps such as Robinhood closed the option of buying stocks in GameStop and the other affected companies to all but the established hedge funds.

Reddit users on WallStreetBets fought back, holding on to their shares and refusing to sell at lower the share price. They got a boost on Thursday from Chinese Bitcoin entrepreneur Justin Sun, who purchased $10 million in GameStop stock to keep up the prices. “It’s time to unite & squeeze out those greedy hedge funds!” Sun tweeted.

A Comeuppance?

Robinhood’s move drew condemnation from lawmakers across the political spectrum. Socialist Representative Alexandria Ocasio-Cortez demanded hearings into the reactions, leading conservative Senator Ted Cruz to tweet, “Fully agree.” Anti-Wall Street rhetoric went stratospheric, with one congressman saying that “South Hedge-i-stan (Wall Street)... are getting a comeuppance from flash mobs of day traders.”

“What you’re seeing,” said former House speaker Newt Gingrich, “is an almost spontaneous cultural reaction in which the little guys and gals are getting together and going after the bigs, so the bigs are having to rig the game in order to survive.”

Most of the anger was directed at Robinhood, which was recently investigated by the feds for promoting companies that paid higher fees when brokering stock sales. Hirsch thinks they may make new rules to better oversee companies that are “too shorted to fail.” Despite the market furor, however, he advises against counting on any major changes.

“This is politicians when people say ‘You must do something,’ and they do something,” he says. “It’s just to get people off their backs.”

Conspiracies theories flew thick and fast. Some pointed to one of the Reddit users who was a CFA analyst — the authoritative voices in stock markets — accusing the hedge funds of being behind this to keep the markets away from the little guy. But Hirsch doesn’t think there’s more to it than just Reddit users purchasing stocks and then trying to protect their assets.

“My personal opinion is that these were just people looking to make a buck,” Hirsch says. “I don’t see the big Wall Street people, who are public on Twitter, that worried about this. They see it as just a handful of stocks and they don’t see it as a broader issue.”

Indeed, Gill, the “Roaring Kitty,” said he always had a dream of building a private race track.

“And now,” he told the Wall Street Journal, “it looks like I actually could do that.” —

(Originally featured in Mishpacha, Issue 847)