Organized Small Investors Plan to Crush Hedge Funds by Buying GameStop Stock

The Wall Street Charging Bull statue in New York City on July 23, 2020. (Michael M. Santiago/Getty Images)
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BY PETR SVAB

News Analysis

A sizable group of small investors has threatened to bankrupt Wall Street hedge funds that have sought to profit from the downfall of the video game retailer GameStop. The investors have organized online to buy GameStop’s stock, forcing billions in losses on the establishment players that had bet on the company’s failure.

The exact origin of the phenomenon is hard to pinpoint but some have attributed it to an anonymous member of the Reddit forum called “r/wallstreetbets.”

The forum sports over 3 million members and focuses on retail investment, meaning investment by individuals, typically of small sums, into stocks and bonds.

Members of the forum noticed that Melvin Capital Management, a hedge fund worth reportedly over $12 billion, was holding a massive short position in GameStop—the company was betting more than $55 million on GameStop’s stock sinking, according to startup investor Shaan Puri. Members of the forum rallied their ranks to bet against Melvin by buying GameStop shares.

The GameStop price had been declining for years, from more than $16 per share in 2018 to less than $4 per share in early 2020, as its business model of selling physical box video games in brick shops was supplanted by online sales.

The company was boosted later last year when Chewy.com founder Ryan Cohen bought a 9 percent stake and joined its board, giving some investors hope that he might revive the declining retailer. But Wall Street analysts were still predicting a downturn.

Around mid-January, the price started to go up rapidly to more than $30 on Jan. 13 and over $40 on Jan. 21. By the next day, Melvin was down nearly 30 percent, and needed Citadel and Point72 Asset Management to shore it up with a nearly $3 billion investment, The Wall Street Journal reported on Jan. 25. By that time, GameStop was up to more than $75.

But that was just the beginning. On Jan. 26, GameStop price climbed to nearly $150 per share. Melvin announced it was able to close its position in the company that afternoon, taking an undisclosed loss, CNBC reported. Many members of the Reddit forum don’t seem to believe the hedge fund in fact managed to close out.

On Jan. 27, GameStop soared to more than $300 a share.

At that point, the Reddit user that allegedly started the movement several months ago by investing some $750,000 in GameStop stood to gain over $16 million on the deal.

Many users also seem to be targeting the stock of Blackberry, a struggling phone company. The stock price has climbed in recent weeks from less than $7 per share to more than $22.

Where Is This Going?

Based on recent popular posts on the Reddit forum, the investors are betting that many Wall Street players are still holding large short positions in GameStop and are struggling to get out of them. The investors are urging each other to not sell and in fact keep buying, even at the high price.

The apparent goal is to force a situation where institutional investors no longer have any GameStop stock to sell, but at least some of them still hold short positions, which would force them to buy the stock from the small investors. If the small investors refuse to sell, the price could climb to exorbitant heights.

How Shorting Works?

Shorting refers to selling a borrowed stock. Let’s say a friend of ours buys two cars for $10,000 each. We have a hunch that these exact cars will get much cheaper in just a few months so we ask the friend if we can borrow the cars for some time. He says it’s ok to borrow one if we pledge our watch as a collateral, but if we want to borrow the other one too, we’ll have to pay a small rental fee. We agree. Right after borrowing them, we’ll sell the cars for a total of $20,000. We keep paying the small fee. Three months later, a new model comes out causing a glut of cars on the market. The old model now costs only $8,000. We buy two and return them to the original owner. We made $4,000 minus the fees by “short selling” the cars.

Alternatively, we borrow the cars and sell them, but then a car factory shuts down, causing a car shortage that sends the price up to, say, $12,000 a piece. We can keep waiting for the price to go down, but at some point the owner may come to us and say he wants his cars back as he wants to make some money by selling them at a higher price now. We have no other option than to buy two new cars at the higher price so we can return them to the owner, losing $4,000 plus the fees on the gambit.

So what is a “short squeeze”? Imagine we are not the only ones in the exact same situation described earlier. When the price of the cars starts to go up and reaches, say, $11,000 a piece, other short sellers may decide to hedge their losses by buying some cars. Their doing so causes the price of the cars to go up even higher, “squeezing” our position.

The GameStop situation is akin to a group of people creating the squeeze intentionally. They organize to buy all the cars they can get their hands on. Eventually, the short sellers can get to a point where they are forced to return what they borrowed by buying from this organized group of investors, since they are the only ones left having any cars for sale. The investors can then virtually dictate the price.

On the other hand, if the short sellers manage to all close out, the stock is likely to drop and those who bought into the rush late would be stuck holding the bag.

Can the Big Guys Stop This?

Shorting is always a gamble since the owner of the stock that’s being borrowed can, at any time, demand it back, forcing the short seller to go buy it at whatever is the current price. In practice, this rarely happens because short selling is accommodated by large investment firms that hold massive portfolios of stocks. If the original owner wants his stock back, the investment firm simply replaces it for the short seller.

That is the case with GameStop shares too. The largest investment manager of them all, the $8.6 trillion behemoth BlackRock, disclosed on Jan. 26 it just sold some 2 million GameStop shares and still had about 9 million left. The company can thus rescue, for a hefty compensation, the hedge funds stuck with GameStop shorts.

Yet some members of the Reddit forum predict that Wall Street had in fact shorted GameStop much more than it lets on. So much that even the BlackRock portfolio won’t be enough.

The New York Stock Exchange halted GameStop trading several times but that didn’t do much. The exchange may eventually resort to a longer suspension.

Government regulators could also look into whether the GameStop rush was fueled by spreading false or misleading information, which would be illegal.

The U.S. Securities and Exchange Commission said in a statement on Jan. 27 it was “actively monitoring” market volatility.

Some members of the Reddit forum reject this, saying that correctly identifying an overly shorted stock and investing in it based on a prediction of a short squeeze is a legitimate investment strategy.

In the evening of Jan. 27 the Reddit forum was made private by its moderators who said they could no longer manage to moderate the onslaught of new activity. Meanwhile social media platform Discord took down the forum’s discussion server.

What Does This All Mean?

Establishment players appear to view the GameStop rush as misguided if not malicious. But small investors seem to view it as a form of revolt as they see institutional Wall Street as unfairly playing the market to its advantage and their disadvantage.

Hedge funds in particular are sometimes seen as taking advantage of struggling companies. Still, if the government steps in, it will probably be on the side of the establishment players, warned Dan David, founder of due diligence firm Wolfpack Research, in a recent Bannon’s War Room interview.

Billionaire investor Chamath Palihapitiya in a recent CNBC interview backed the small investors’ right to do what they are doing, even if it doesn’t turn out to their advantage. As long as institutional investors are allowed to take advantage of short term swings in stock prices, the small guy should be allowed to make analogous moves too, he said.

“There’s a small part of momentum, there’s a part that’s fundamental analysis, and then there’s a part that’s just sticking it to the man,” he described of the situation.

Update: The article was updated to reflect that in the evening of Jan. 27 the Reddit forum r/wallstreetbets was made private by its moderators who said they could no longer manage to moderate the onslaught of new activity. Social media platform Discord took down the forum’s discussion server.

Follow Petr on Twitter: @petrsvab
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