What’s Causing the GameStop Stock Trading Frenzy?

What’s Causing the GameStop Stock Trading Frenzy?
Photo: Dev Chatterjee, Shutterstock
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You might have seen headlines this week about the sudden surge in stock prices for moribund companies like GameStop (up 400%) and AMC (up 375%). But what about Blockbuster? Yes, they still exist as a penny stock — and they’re up over 2000% from earlier this week, too. What’s going on?

Rise of the retail investor

In traditional value investing, you find an undervalued company, buy the stock while it’s cheap, then make money when it appreciates. In the case of these stocks, valuation doesn’t really matter. After all, no one expects much from GameStop — a chain of brick-and-mortar stores struggling through the pandemic with a dated business model — let alone the mummified husk of Blockbuster.

So why aren’t these companies’ stock moves being driven by their fundamentals? Because what we’re really dealing with is a short selling battle between big hedge funds and increasingly powerful and organised retail traders who have grown in influence due to commission-free trades, the use of individual investor apps like Robinhood, and the power granted them by social media and the internet — including the popular, raucous subreddit r/wallstreetbets (self-billing: “4chan found a Bloomberg Terminal”) — to work together.

What Is Short Selling?

Short selling a stock is akin to placing a simple bet that a company’s stock price will go down, and as such it’s often demonised as profiting off of failure. However, academics and investors believe that short selling improves market efficiency by making it easier to trade stocks and by...

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A series of short selling bets

To understand what’s happening, you need to know how short selling works. Commonly used by large, institutional investors, short selling involves placing a short term bet that a company’s stock will go down. Essentially, these investors borrow that company’s stocks from a broker-dealer, sell them on the market immediately, then buy them back when the price drops, at which point they pocket the difference and return the stocks to the broker-dealer. These are risky investments, as the stocks must be returned to the broker-dealer eventually, and there’s no guarantee that a stock price will ever go down.

Thing is, these institutional investors got greedy with their short selling, as they were shorting more than 100% of their shares outstanding for these companies (139% in the case of GameStop). That means the investors bet more shares than actually existed, which is highly unusual. This caught the attention of the aforementioned retail investors, providing them with an opportunity to both make money and also have some lolz at the expense of the big hedge funds,

The retail investors’ squeeze play

So, what happens when a bunch of recreational investors invest in a shorted stock, increasing its price? The short sellers lose a lot of money. Worse, the original broker-dealer can demand their shares be returned immediately as part of a margin call — forcing the short seller to buy back shares they’ve already sold, even if they now cost a lot more than they sold them for. And when they do so, the stock price continues to climb — part of a feedback loop known as a “short squeeze.

In what’s been dubbed “revenge of the nerds,” individual investors are indeed making money off of these short squeezes, and it’s simply caught hedge fund managers off guard. Just as with short selling, making money off a squeeze requires good timing and discipline, as an investor will want to sell when the buy-back frenzy from short sellers is at its peak. Another Reddit-approved strategy has been to call up brokers and insist they don’t lend out shares for shorting — a standard right of clients — thus driving the stock price up even further.

In theory, the speculation ends when enough short sellers finally cut their losses and dump the stock — but then again, in theory, Reddit could hold a “memestock” like GameStop aloft for as long as they want.

Is this illegal?

According to Bloomberg, the SEC is likely to “scrutinise” the trading, and the Treasury Department says they are “monitoring” the situation. However, charges of market manipulation typically require some proof that the investors knowingly spread false information to dupe other traders into buying or selling a stock. In this case, you could argue that the giddy YOLO motives of Redditors have actually been rather transparent.

As James Cox, a Duke University School of Law professor, put it to Bloomberg:

“It’s an enforcement nightmare for the SEC. The question is: where does the manipulation start and when does trading on your own hunches and publicising your hunches start?”

Typically, successful enforcement cases typically hinge on the SEC showing that investors knowingly spread false information to dupe other traders into buying or selling a stock.

As Bloomberg’s Matt Levine points out, to pursue such a case here, the SEC would have to take unprecedented measures — if they do take any action at all.

Will this affect your investments?

All investments in the stock market carry some risk, and stock volatility is part of that risk. However, it’s not yet clear how these retail investor moves affect traditional, long-term value investors. The more immediate concern might be that FOMO retail investors will take on risky bets and lose money they can’t afford to part with. The bottom line is that individual investors should be fully aware of the risks they’re taking, especially for any investing phenomenon being described with words like “frenzy” and “craze.” And if you are feeling an itch to use an investing app like Robinhood, read this CNBC post about the risks first.

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