You might be wondering how GameStop, a struggling icon of 2000’s malls best known for driving hard bargains with teenagers over the price of used video games, has become the center of the investment universe. You are not alone. 

On January 4, 2021 a single share of GameStop was worth $17.25 and on January 27th it had reached a high of $380. This meteoric rise, and the forces behind it, are part investment strategy, part pop culture, and part protest movement.  

Let’s take a look at the factors in play and what is causing this sensation.

The Tools (starting with the basics):

Stock market: At its core, the stock market is the way we allocate capital to companies. When buying a stock, a market maker takes your buy order and matches it with an investor that is selling that same stock. In essence, to buy a stock you need a seller, and to sell a stock you need a buyer. Over the long term stocks are supposed to reflect the value of the company that they represent. In the short term, there can be deviations – the more people who want to buy a stock, the more it will go up.

Efficient market hypothesis: This theory has long been the cornerstone of investing. It states that “stocks trade at fair market value and their price reflects all public information about the underlying company.” In the story of GameStop, this theory, and the idea that stocks are a representation of the value of the company they represent, are being tested.

Short selling: Is a trading technique used when the investor believes the stock price of a company will go down. The investor sells the shares, and then in order to close the position, the investor buys the shares at market value. In a short, you “borrow” shares to sell first and then buy them back later to close the trade. This is the opposite of a “regular” trade where an investor buys a position and then sells the position to close the trade. 

For example: if an investor sells 1 share of Stock A short at $50 on Monday and on Wednesday the investor buys Stock A back at $40, the investor’s trade is +$10. If the investor waited until Friday to buy Stock A back at $75, the investor’s trade is -$25.

Investors can tell what stocks have the largest short positions taken against them by looking up short interest, or the percentage of the shares sold short compared to the number of shares outstanding (more on this later).

Short Squeeze: Occurs when the price of a stock that has been heavily shorted jumps in price. This forces traders with short positions to buy the stock in order to close out their positions to meet liquidity needs or to stop further losses. These purchases cause the stock’s price to increase even more.

Call Options: Contracts that give the option buyer the right, but not the obligation, to buy a security at a specified price within a specific period. Reddit users have purchased out of the money call options as a strategy to realize potentially larger gains with lower upfront investment requirements than simply purchasing the stock.

The Players

Reddit: Several investing focused Reddit pages are credited (or blamed) with fanning the flames of this phenomenon. On these message boards, commenters openly discuss their trades and often the motivations behind them; everything from trying to make some money for a nice dinner to trying to cause a billion-dollar hedge fund to collapse.

Social media has allowed these groups that do not have traditional leadership and/or organizational structures to rally around a common goal or in this case, stock. Collusion, with the aim of manipulating markets is illegal, but that is a very difficult case to make when considering a public message board and individual investors with no formal links to one another.

Hedge Funds: Private investment funds that can adopt a wide range of strategies to accomplish the goal of adding value and making money for their investors. Hedge funds have become the target of the Reddit crowd as they hold a large amount of the short positions and are seen by many retail investors as an exclusive vehicle of the wealthy. 

Robinhood: An online trading app that claims its mission is to “democratize finance for all” has become massively popular within the last year. It has become especially popular during lockdowns caused by COVID-19. In the last week, it has become the most downloaded free app on the Appstore (Reddit was in second place), as new investors opened accounts to get in on the craze.

However, on January 28, the app announced they would no longer allow its users to buy GameStop stock; a move met with much controversy and an apparent exodus of users from the app. This latest restriction has been met with allegations that Robinhood took action to protect Hedge funds (giving to the rich) by not allowing the retail investors to participate (taking from the poor), which is ironically the exact opposite of the app’s stated mission. 

Retail Investors: A generic term for investors who are not, or are not working with, investment professionals. Most of the investors participating on the Reddit message boards self-identify as retail investors. Some of them are able to invest tens of thousands of dollars at a time, others as little as $50.

So how did we end up here?

Retail investors that populate the message boards on Reddit believed they had come up with a new strategy; one that could be used to make massive gains quickly and stick it to the rich and powerful hedge funds at the same time.

First, they identified stocks in the market that had the largest short interest (i.e., the stocks that had been sold short the most). This is public information that was readily available. They also looked for a company with a low share price that was not traded in great volume, so their trades would have a bigger impact. Somehow, the message board arrived at GameStop, and the company’s stock became a battlefield.

As they started purchasing shares of the stock and call options, the price of GameStop started to rise. As word spread like wildfire around Reddit and Twitter, more investors of all types purchased GameStop stock, causing the price to rise even more. With each new headline and each new social media post, more investors were attracted to the story and began buying the stock.

With each pop the Hedge funds and those who had sold the stock short were put in a more and more painful position, as their trades lost more and more money. Then, the short squeeze began as the stock took off when some large hedge funds began to exit their short positions at massive losses. In order to exit their shorts, they had to go buy the amount of stocks they were short in the first place. These massive purchase orders caused the stock to skyrocket.

Where do we go from here?

By January 28th, the phenomenon was international news. Celebrities, investment professionals, and politicians were all commenting on the rise and fall of GameStop stock. Some urging the investors on, others worried about the long-term effects this would have on financial markets. The end result has yet to be seen, but the GameStop phenomenon, along with other names like AMC, Nokia and Blackberry, have further exposed the risk investors take when investing in the stock market, especially shorting stocks.