What in the world actually happened with GameStop this week?
posted Saturday Jan 30, 2021 by Scott Ertz
This week has been an absolutely fascinating one for the stock market, and everything that surrounds it. A stock that was significantly overpriced went through the roof instead of falling. A company called Robinhood, which bills itself as the democratization of investing, prevented people from investing. Reddit and Discord closed servers over racial discrimination. Google deleted thousands of app reviews. And, weirdest of all, Representative Alexandria Ocasio-Cortez and Senator Ted Cruz agreed on something. But, what exactly happened?
What is Short Selling?
This part has been one of the hardest to understand, so let's cover it quickly. Shorting a stock is a process in which an investor recognizes that a stock has been mispriced. This could be because of a misunderstanding of the business's dealings, an overreaction to an announcement, or simple market fluctuations. The investor will then borrow shares of a stock from another investor, traditionally large institutional investors, and sells them at the current price. The hope is that the price will correct itself in the short-term, lowering below the price they sold it at. The shorter will then repurchase the number of shares at the new price, and return them to the investor from which they borrowed them, with a small fee for the lend.
Shorting a stock does not mean that an investor is trying to destroy the price of a stock, but simply that they believe the stock is mispriced and is about to correct. For an investor to effectively destroy the stock itself, they would have to borrow and sell the shares to a market that doesn't want to purchase them, which would drive the price down. But, that would defeat the purpose of the entire process for the investor.
A group of amateur investors on Reddit board /r/WallStreetBets noticed that several hedge funds had short positions on GameStop. In an attempt to squeeze the hedge funds, the group all decided to make purchases of GameStop shares to try and drive the price up. Because of the size of the group, the price was driven up enough that the paradigm shifted, with WallStreetBets seeing a return and the hedge funds seeing a loss. Short squeeze is a fairly standard investment practice, so at this point, there was nothing particularly interesting about what was happening.
The big change happened when people who were not involved in the investment heard what was happening and decided they wanted to get involved. Some thought they saw the potential for financial gain, while others thought they were robbing the rich in order to feed the poor. Either way, it was a misunderstanding of what was actually going to happen next.
What's the Next Step for Investors?
As part of a short squeeze, once the investors with the short positions sell, it's a mad dash to get out. The sale of the short shares will signal the height of the price, so those invested in the squeeze will need to sell quickly, before the stock price inevitably crashes. The people who hold the stocks the longest are going to get the lowest price, and are therefore most likely to get harmed by the process.
The Reaction Is Way Worse
There is nothing illegal or immoral about short selling. There is nothing illegal or immoral about short squeezing. However, what happened after the initial squeeze has caused some issues. Because WallStreetBets never claimed that the price of the stock was going to go up, the actions do not constitute a "pump and dump" fraud. The actions could potentially be considered a Ponzi scheme under the right light, but will likely not be charged as such.
The real problem has been the overreaction from investment platforms, in particularly Robinhood. Despite the platform not being a true and proper investment or trading floor, it acts close enough. The big difference behind the scenes is how shares are purchased and distributed. Because of the behind the scenes concerns, the company decided to stop the ability to purchase shares of GameStop. Some saw this as a reaction to threats from institutional investors, while others saw it as a reaction to government interference. In reality, it was likely a reaction to protect itself from its own purchase and sale system.
No matter the reasoning, the perception of the action was a huge problem. Customer felt like they were being harmed by the establishment they thought they were trying to harm. That perception led to literally thousands of app users posting 1-star reviews for Robinhood on the app stores. The influx was so severe that Google felt the need to intervene. The company has confirmed that they deleted "at least" 100,000 negative reviews of the app from the Play Store. They claim that the review system was being misused, and therefore the reviews themselves were invalid.
So, What is the Problem?
The real problem that occurred here was the odd misunderstanding of what was happening, that will inevitably lead to the opposite of what people thought was the goal. The amateur investors that got into the practice late in the process, particularly those who bought in after the short squeeze forced the institutional investors to sell their positions, are going to lose their shirts.
Before the process started, the stock price was already inflated above its proper value. It was going to drop, if not for the intervention from Reddit. But, because the stock skyrocketed, the amount of loss that is coming is going to be significant. But, the hedge funds and other institutional investors are already out. Yes, some have filed bankruptcy and taken out new lines of credit under other corporate entities, but they will survive, because they are setup to handle loss.
Regular people, who invested their savings into a stock that is 10 times its proper price, are going to see that money thrown away, likely to institutional investors who will respond to the overcorrection, will get the stock back for a deal, far below where they had their short positions a week ago. The ones who will win the biggest are those who organized the scheme and likely got out before they got harmed, and instead made a ton of money in the process. Institutional investors will win, but in the long game - not this week or month. Wall Street did not get robbed in favor of the little buy - the little guy is the one who will end up losing in this scheme.