How does an almost bankrupt, dying company’s shares suddenly rise in price by almost 1500% in just three weeks, causing hedge funds to lose almost $19 billion? This David and Goliath moment shocked many around the world, as powerful hedge funds including Point72, Melvin Capital and Citron Research lost billions of dollars. The massive stock-market shake-up originated with amateur investors on social media platforms when “ordinary” people joined together and followed the original influencer, known by the username “Roaring Kitty”, to short squeeze GameStop’s stock. Is this a turning point in the way the stock market operates and if so, what are the ramifications for the future?
A couple of years ago, an unknown technology consultant, Jaime Rogozinski started the subreddit “r/WallStreet Bets” with the aim of providing information to new investors about the stock market and lowering the barrier to entry for receiving financial information. Several years later it has amassed around 9.4 million subscribers, allowing huge numbers of people to confer and collaborate. This enabled thousands of amateur investors to carry out a ‘short squeeze’ on Gamestop shares.
A short is when someone believes that the shares of a particular company are overvalued and are imminently going to drop in price. This prompts them to borrow some of those shares from a broker and sell them. Then, when the price of those shares decreases they buy back the shares and return them to the broker, thus making a profit. For example, you borrow ten shares of Tesla and sell them for $50 each, giving you $500. You now have $500 and the obligation to buy and return ten shares. If the stock falls to $10 a share, you could repurchase the ten shares for $100 and make a profit of $400.
A short squeeze is when a stock, which has been shorted by many people, jumps significantly in value, forcing those who shorted it to buy the stock at a higher price than they sold it at in order to forestall potential further losses, thereby causing them to lose money. These short sellers are contractually obliged to give back the stock that they borrowed and therefore have to buy the stock at whatever price the market dictates. This ‘scramble’ from investors further pushes the price up reinforcing the cycle.
Gamestop was a struggling American video game retailer, an important symbol for many Americans who have fond memories of Gamestop stores from childhood. Previously a thriving business, Gamestop suffered a marked decline due to a massive increase in people buying digital games. In 2019 Gamestop reported a record breaking loss of $673 million and in the first quarter of 2020 recorded a $165 million loss. It seemed that Gamestop was on its last legs due to the rise in popularity of online games and the pandemic, which caused the closure of all 3500 stores. However, in a monumental turn around, the price of one share rose over three weeks by 1500% to almost $500 from just $3. This caused hedge funds to lose $19 billion, as they had taken short positions on the stock and had to buy it back for a hugely inflated price. Approximately 140% of GameStop’s float (the portion of shares of a corporation that are in the hands of public investors) had been sold short, further worsening the damage to hedge funds. Some shorted shares had been re-lent and shorted again. Gamestop is not the only company to be short squeezed by individual investors. AMC Networks, Macerich co. and Virgin Galactic are just a few of the other stocks to be squeezed by the subreddit.
However, this short squeeze caused even more controversy when commonly used trading apps limited access as a method of controlling the market, preventing the short squeeze from continuing. Trading apps, such as RobinHood and E-Trade, are used by many amateur investors as there is no commission fee and they are easily accessible. Robinhood stopped investors from buying Gamestop shares, only allowing them to sell, thus slowing the short squeeze. Robinhood’s co-founder Vladimir Tenev claims that they had to do this as their platform could not handle the amount of traffic and they had to protect investors from a potential crash. Tenev said “We are in a historic situation where there is a lot of activity and a lot of buying concentrated in a relatively small number of symbols that are going viral on social media”.
Some claim that this was market manipulation and a type of stock market abuse, as it was a deliberate attempt to interfere with the free and fair operation of the market. A barrage of class action lawsuits have followed from customers believing that it was done to manipulate the market for the benefit of hedge funds. However, lawyers maintain that regulators would need to find evidence of deception to prove market manipulation. Allison Herren Lee, the acting chair of the SEC (Securities and Exchange Commission), stated, “Extreme stock price volatility has the potential to expose investors to rapid and severe losses and undermine market confidence”. The Securities Exchange Act of 1934 makes it illegal to use “any manipulative device or contrivance” in buying or selling regulated shares, yet usually regulators have interpreted “manipulative trades” to involve deception, which does not appear to be the case here. Even various politicians have expressed their opinions, with people like Republican Senator Ted Cruz and Democrat Congresswoman Alexandria Ocasio-Cortez speaking out against Robinhood’s actions.
This raises the question of whether amateur investors should have this much access to the stock market? Many would argue they should. A lower barrier to entry gives people more opportunity to make profit and further increases equality of access to the stock market. The more information that is widespread, the easier it is for people to make financial decisions, which is why social media is such an incredibly powerful tool. Even though this may create more volatility, the overall benefit to the majority of people is greater and investors should learn to react and pay attention to social media platforms in the future. In this current age, the market is the most ‘equal’ it has ever been between Wall Street and retail investors. This phenomenon would only be possible in this new digital age where investor information and co-operation is widespread and the rise of frictionless, no trading fee platforms allows retail investors to invest.
Yet it is still a mystery as to why r/wallstreetbets decided to short squeeze so many stocks and go after hedge funds. One plausible explanation is that people wanted to challenge large institutional money-makers on Wall Street, as they felt they excluded the majority of the population. However, this move could also have been to make profit alongside political motives. Many people jumped on the bandwagon, seeing the early success of some investors, and were persuaded by those already on the subreddit, adding to the frenzy.
This is an unprecedented situation, and the future is uncharted. It may be the start of a new trend of social media platforms influencing the stock market. Hedge funds and investors will definitely pay much more attention to often disregarded retail investors and the sites they use. On the other hand, this could just be a passing phenomenon, with prices quickly normalising due to the shares being highly overvalued. The future is unknown, but one thing is certain: this has been a big wake-up call for many and will keep hedge funds on their toes, unlikely to underestimate retail investors again.