In January 2021, GameStop (GME) stock was at the center of a saga more exciting than some video games they sell. Trading around $18 in early January, the price reached a peak of $483 on January 28th. This meteoric rise wasn’t directly related to anything the company did. Rather, the buying frenzy comes from Reddit forum Wall Street Bets setting out to punish wealthy hedge funds for risky shorting, margin purchases, and options trading through a short squeeze.
What are these practices, exactly? In layman’s terms, shorting a stock means selling a stock for a certain price believing it will drop in the near future. While this strategy can turn a profit if the prediction comes true, there is technically no limit to how far a stock price can rise. Losses could be infinite if the short seller guesses wrong. To buy on margin is to purchase with borrowed money, supercharging gains and losses. Finally, options allow investors to buy the right to purchase a stock later instead of the stock itself. Usually, an option contract includes a specified price at which the investor will buy. Like shorting, option trading can generate total losses for an investor if they guess the wrong price. Seeing as certain hedge funds engaged in all 3 practices against GME stock, they met losses on all 3 fronts when Wall Street Bets reversed the stock’s trajectory.
The worst loser was Melvin Capital. It’d been the most exposed to betting on GameStop falling and had lost $6.6 billion, more than half of their total value as a hedge fund. However, short sellers weren’t the only people who suffered losses as a result. To raise cash, short sellers had to sell some other stock holdings, leading to a chain of events that dropped the S&P 500 by 2.6%. January 27th was the worst stock market day in three months. Thanks to a chain reaction of events, people who had had nothing to do with shorting GME stock lost money on their investments.
ValueWalk's Raul Panganiban David Barse, Founder and CEO of XOUT Capital, and discuss his unique approach to investing. Q1 2021 hedge fund letters, conferences and more The following is a computer generated transcript and may contain some errors. Interview with XOUT Capital's David Barse
Enraged, the Wall Street establishment turned to regulators for help. Unfortunately, no help is forthcoming. The SEC is only monitoring the situation. WSB discussing stocks on a public forum is no crime. The only group likely to be punished is the RobinHood trading app, who blocked user purchases of GME and other stocks before reversing their decision. They face a class action suit for market manipulation.