- GameStop Corp. stock, which trades on the New York Stock Exchange, became the pawn of an unusual power struggle between hedge funds and retail investors led by an investing forum on Reddit
- One of the leaders of the GameStop buying effort on the subreddit has reportedly gained over $50 million from manipulating the market, leading some to call for federal investigation
- Online market manipulation is not going away – copycat efforts have already begun with other distressed firms such as AMC Theaters and BlackBerry
- Investors may be damaged if abandoning a long-term strategy to chase short-term profit
Recently, the media has been covering unusual trading of a publicly traded stock, GameStop. The story has made international news and has led many people – investors and non-investors alike – to wonder not only what happened, but if there are opportunities or risks that the story presents. To take things a step further than what is available through traditional news media, here is our take on these recent events from a planning perspective.
Why is GameStop such big news?
GameStop Corp., a nationwide chain of computer games stores, had been in financial trouble even before COVID-19 hit early in 2020. Poor foot traffic during the lockdowns forced hundreds more GameStop stores to close, and with the gaming public shifting away from physical games and toward digital downloading, the prognosis for the company looked grim. Some hedge funds, notably Melvin Capital Management, sought to capitalize on GameStop’s woes by selling a great amount of GameStop stock short. These short sales were disrupted in a spectacularly unusual manner.
What is short selling?
Selling stock short is an advanced, legal technique where one sells stock they do not own yet. They are contractually obligated to find stock to replace the borrowed shares and give those shares to the buyer (called closing the position) before or at the time the contract ends.
Can you give me an example?
Let’s say Widget, Incorporated is listed on the New York Stock Exchange for $10. The short seller thinks the company will do poorly and expects the share price to drop under $5 within nine months. The short seller will sell borrowed stock at $10 and must replace the stock at whatever price they can find later. If the stock drops in price and the short seller closes the position at $4, their profit is $6 per share. Of course, if the stock price rises, the potential for the short seller to experience loss is unlimited. This makes short selling a rather risky technique. GameStop short selling was so active that the short sales were reportedly up to 140% of float, which means that for every 10 shares of GameStop stock, 14 had been sold short.
14 sold short for every 10 shares out there? Isn’t that impossible, or at the very least illegal?
It’s certainly a very unusual situation, but neither impossible nor illegal. Consider this: the average human heart pumps about 2,000 gallons of blood a day. Of course, you do not have 2,000 gallons of blood in your body: you have roughly ten pints, or a bit more than one gallon. Those ten pints or so are circulating constantly.
In an actively trading market, stocks are also circulating constantly. To fulfill all of the short sale contracts, the short seller will have to buy any stock they can find on the open market – then rebuy some of the same shares when they reenter the market, presumably at an even higher price.
So what happened?
Large hedge funds shorting GameStop stock was not newsworthy. GameStop’s very public troubles made them a prime target for short sellers: selling struggling businesses short is their bread and butter. In this case, though, there was considerable agitation to buy GameStop stock in a particular forum on Reddit, the massive online discussion board. As more people followed suit and bought GameStop stock (if for no other reason than to cripple or bankrupt the short-selling hedge funds), the share price rose to dizzying heights. To put things in perspective, the share price of GameStop on April 27, 2020 was $6.05 per share: the short seller expected the stock to go lower than this. Instead, by Thursday, January 28, 2021, the stock was trading at well over $400.00 a share. Melvin Capital Management reportedly closed their short position with a loss of $3.75 billion.
What does this mean for the average investor?
For the average investor who diversifies their holdings prudently, the drama surrounding GameStop should mean little. Only a handful of ETFs hold an appreciable amount of GameStop stock, and the average investor does not invest in hedge funds. Nevertheless, as GameStop’s rising share price became front-page news, many retail investors with little to no investing experience have purchased GameStop stock at prices which would have been unthinkable four short months ago – likely chasing the example of “DFV”, the main agitator in the subreddit which led the charge to buy GameStop stock, who reportedly turned an initial investment of $50,000 into unrealized gains of over $50 million as of Thursday, January 28, 2021. Already, there are copycat movements seeking to buy shares of other distressed companies such as AMC Theatres and BlackBerry. The unusual activity in these stocks has now reportedly attracted regulatory attention.
Those who try to time the market to chase profit must be right twice – they must get in at the right time and get out at the right time. As this story is now international news, getting in at the right time is now probably next to impossible, which makes finding a time to exit even more problematic.
Low intrinsic value of these stocks compounds the risk. While it is understandable to be tempted to follow the example of a person who has allegedly made a $50 million profit, it would be well to remember that the stocks being manipulated were chosen precisely because they have little fundamental or technical investment value.
In the pre-digital age, con men would buy shares of distressed penny stocks and set up “boiler rooms” with accomplices working a phone bank to drum up the stock price, then dump their own stock leaving their victims – the investors who were urged to buy those thinly traded penny stocks - to take losses. This is not dissimilar to how GameStop and similar stocks are being used. Simply put, the subreddit is so massive that it has made the boiler room concept scalable to influence stocks trading on major exchanges.
Investors with a long time horizon should not abandon healthy diversification in their portfolios. If you are not sure where to start, or just want a second opinion on your existing strategy, please contact us.
This article was prepared by Pegasus Financial Planning. Advisory services are offered through Sowell Management. Pegasus Financial Planning and Sowell Management are not affiliated. Sowell Management does do business under the name of Pegasus Financial Planning. This information is intended to be educational and is not tailored to the investment needs of any specific investor.
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