By now, the majority of you would have heard about GameStop and a lot of incomprehensible financial jargons surrounding stocks. This article is to provide some guidance about those jargons, as well as provide some basics on what actually happened.
What is GameStop?
GameStop is an American brick-and-mortar retailer store which sells games, consoles, and electronics. The business has not doing well because the game industry has completely revolutionized. The pandemic made their financial situation even worse.
The GameStop Frenzy and Reddit
Reddit is a social media platform where people join forums ,ranging from anime to history. One such forum is called Wallstreetbets, which has over 4 million users. They discuss stock trends and where they are going to invest. Members of the Wallstreetbets collectively decided to buy the plunging GameStop shares, astronomically increasing its demand and hence its price by a whopping 822% on Monday, 25th January. Specifically, the stock price increased from $17.25 at the beginning of 2021 to $159.18 on Monday. This put a huge dent on the value of hedge fund companies which had a short position on GameStop Shares. Companies like Point72 and Melvin Capital lost 15% and 30% of their values respectively. In total, the loss of all Wall Street hedge funds was $5 billion.
The GameStop Frenzy and Shorting
This begs the question of what a short position actually is. In a nutshell, shorting is the opposite of the popular adage ‘buy low sell high’. Shorting occurs when hedge fund managers speculate that the share value is going to decline in value in future and they bet on this speculation in a very sophisticated manner. They borrow the shares from an institution, paying a premium for it – similar to taking up a loan and paying interest payments for it. Then, they sell it at the current market value and buy back those shares later at a lower price and return it to the lenders. If the price does indeed drop in future, then they make a profit which is equal to the difference in the price they bought and sold it at. However, if the stock price moves up instead and keeps on rising, then such speculators end up making a huge loss on those shares.
For example, your cousin has a notepad worth $5. You ask to borrow that notepad and promise to return it back in a month. During that one-month period, you actually sell the notepad to someone else for $5. You are betting that in one month, you will be able to buy back the notepad from that person at a cheaper price. After one month, if the price does indeed drop to $2, you would be able to buy the notepad back at $2 and return it back to your cousin. The profit you would make is $3. However, if the notepad price increases to $50 instead, you would have to buy it back at that price, making a loss of $45. That is what shorting is all about.
Indeed, this is a very risky business and can cost millions of dollars if the share prices rise too high. In GameStop’s case, the hedge fund companies incurred a huge loss since the hedge fund managers took a short position on the GameStop shares and the Reddit users made the price soar by significantly increasing its demand. On the other hand, the stockholders GameStop made huge gains from this frenzy. Ryan Cohen, who owns approximately 9 million shares of GameStop, made around $3 billion from this event.
Motivations Behind This Incident
There are various reasons why the Reddit users decided to do this. Some just did it for a good laugh, some merely wanted revenge on the Wall Street hedge fund managers for being ‘rich’, some just wanted to support GameStop, while others just wanted to check the power of collective investors who do not have millions of dollars or the proper expertise to invest in the stock market.
Is it legal to intentionally dent a hedge fund?
In order for the plaintiff (the hedge fund companies) to put an allegation on the defendants (the Reddit users) under the Securities Exchange Commission (SEC), they need to prove that the defendants intentionally spread false information. Simply letting others know what you are going to invest in is perfectly legal. Furthermore, the plaintiff also has to prove under SEC 1934 that the defendant possessed an ability to distort the market prices and artificially inflated it with an intent to do so.
This incident has well displayed the power of individual investors possessing only a small capital to move the market if they take collective actions. If this continues to happen, then hedge funds and asset management sectors might crash in the long run.
Wriiten by: Uzma Islam