An attempt to explain what happened this week in plain english
By now, you have probably seen the news about GameStop and its stock. I have found most articles and posts on the subject to have either an intermediate level of investment technicality or are simply too long. I am going to try to simplify the situation as best as possible. I will not define terms like ‘stock’ or ‘brokerage’, as it will increase the length of the post. Google any term you don’t know or message me and I will explain further.
When you trade a stock in the market, you can primarily do four things:
- Buy the stock
- Sell the stock (if you already own it)
- Short sell the stock. This means having the investment firm where you hold your account lend you the stock and you sell it. You eventually will have to buy it back and give back to the investment firm. You make money by selling it high and buying it low later.
- Buy to cover the stock. This is the process of buying back the stock you borrowed and giving it back to the firm that lent it to you.
GameStop (GME) is a company that sells video games and consoles in retail locations across North America. The rise in online shopping and ability to buy games and download them directly on the consoles has been very bad for the company over the last few years. The stock price has slowly gone down from ~$55 in 2013 all the way to ~$2.60 in March 2020. From May to August 2020, the stock price ranged from $4 to $6.
The pandemic disproportionately affected GameStop, since most of its locations were closed during the first lock downs. Several hedge funds, which are investment firms that invest institutional investors money in different types of strategies, decided that the company was going to to bankrupt and decided to short sell the stock.
This is the part where things get a little strange. GameStop has about 65 million shares outstanding of which about 47 million are available to trade at any given time. However at it’s peak about 71 million shares of GameStop were shorted. How is that possible? Let me explain with a little exercise:
- Jorge has an account with XYZ Inc. Jorge decides to short GME stock, so XYZ Inc. lends him 1 share of GME and Jorge sells it to Sally.
- Sally, who also has an account with XYZ Inc., buys the 1 GME share from Jorge.
- Jorge wants to sell short another share of GME . XYZ Inc. lends Jorge Sally’s 1 share. Jorge sells the 1 share to Bob. Jorge is now short 2 shares, even though technically he sold the same share twice.
This is an extreme oversimplification of the process, but I hope you get the idea.
Both the 47 million shares available to trade (known as the float) and the 71 million shares shorted at its peak (known as short interest) is public information. Amateur traders that exchange ideas in a sub-forum of Reddit named r/wallstreetbets came up with the following idea: What if we buy as much GME stock as possible, and not sell it, essentially reducing the float to the point that short sellers have a hard time finding stock to buy to cover?
(NOTE: This wasn’t the only reason amateur traders were buying GME stock. Some thought that the business could be turned around. Others thought that they could make a quick buck. But the reason above is the reason we are in this situation)
It is time to oversimplify another process: collateral.
When you short sell a stock, your potential losses are infinite. Let me explain:
When you short sell a stock, you have to eventually buy it back and give to the firm that lent it to you right? So lets say you sold short 1 stock at $100, but the next day the stock is worth $1,000,000 and the firm is asking for the 1 stock back. What happens then? You have to find $999,900 to buy back the stock. Crazy right?
Investment firms have to protect themselves against this possibility. What typically happens is that as the stock price is rising, the firm is going to ask you for collateral. collateral can be cash or stocks in other companies. For example if you sold short 1 stock at $100, and the next morning the stock is at $150, the firm is going to call you and ask you to deposit $50.
Back to the r/wallstreetbets amateur traders, many jumped on the idea of buying as many shares of GME as possible and not selling, reducing the amount of shares traded at any given time. This demand for GME stock started driving the price up, which meant short sellers started losing money and increasing their collateral. The media picked up the story which created a snowball effect: more people started checking out r/wallstreetbets and jumping in on the trade. Some bought 10 shares, others 10,000. Hedge Funds started jumping on both sides of the trade. Business people and celebrities started commenting on the situation. Government started to get worried. This is unprecedented! A coordinated effort to reduce the float and increase the price so that short sellers have to post collateral and/or struggle to find shares to buy?
Yes. For the first time in financial markets history, we are watching a potential crowd sourced short squeeze.
A short squeeze is when a short seller has to buy back the stock they shorted at any price in order to mitigate their losses. In 2008 there was a very famous short squeeze which made Volkswagen the most valuable company in the world for a brief period of time.
The internet and the media are not focusing enough on the fact that this is a coordinated effort.
This week, hedge funds that shorted GME stock are either being forced to increase their collateral or forced to buy to cover their GME stock. This is information is not public so we don’t know exactly what’s going on, but the volatility of the price is telling us there is something going on behind the scenes.
So what is the end game with GameStop? There are many scenarios, but the end game of the central thesis is when short sellers have bought to cover the GME stock they shorted. How do we know when this happens? When we see the short interest decrease from ~88% to more manageable levels.
This primer is intended to those who know very little about investment finance. I oversimplified the situation but my intention is for this post to be a place to start if you want to know what’s going on regarding GameStop.
This is not investment advice. For informational purposes only. I held no position in GME at the time this was published.