The shares of GameStop Corp, a struggling game retailer in the US, have surged by more than 1,600% since December 31. The reason behind this phenomenal rally can be attributed to the collective power of small investors and social media platforms. It has caused quite a stir in Wall Street and made us realize the importance of having well-defined regulations in stock markets. To understand the logic behind this huge rally in GameStop, we need to learn the concepts of short-selling and short squeezing. We shall also look into recent developments surrounding this controversial topic.
What is Short Selling?
Short selling or ‘shorting’ refers to when investors try to make money by betting that a company’s share price will fall. In this method, a trader borrows shares of a particular company from a broker and sells them at market price- with the hope that prices will fall. He has an obligation to return these shares to the broker at a future date. The proceeds from the sale of these borrowed shares get credited to the trader’s account.
If the share prices of that company fall, the trader would be able to purchase back the shares from the market at a lower price. Profit is made on the difference between the price at which the shares were borrowed and the price when they are returned. Short selling is primarily conducted by large investment firms (such as hedge funds) and experienced investors. Also, the number of short positions in a company’s stock can be higher than the total number of shares available. The concept of shorting is made easier with the example given below.
Suppose a trader expects the stock price of a company named XYZ to crash sometime soon. This assumption could be based on the fundamental and technical analysis he conducts on that particular stock. He would then decide to borrow 10 shares of XYZ stock from a broker and sell them in the market for Rs 50 each. Thus, he receives Rs 500 in cash. He has an obligation to purchase and return the 10 shares of ABC stock at some point in the future.
In case the stock price of XYZ falls to Rs 10, the trader can purchase the 10 shares (that he owes to the broker) for Rs 100 and make a total profit of Rs 400. [Ie, Rs 100 subtracted from the Rs 500 he received initially by selling the shares]
What if the trader’s analysis failed and the share price of XYZ went up to Rs 250? He would have to spend Rs 2,500 to buy back the 10 shares that he owes to the brokerage. He still gets to keep the Rs 500 he earned from selling the shares initially. However, the trader has lost Rs 2,000 in this scenario.
What is Short Squeezing?
When a company’s share price starts rising, shorts would panic and be forced to close their position. [Shorts are those traders who bet that the company’s stock would fall] They would buy up the shares that they owe their brokers and return them. More individual investors will start buying shares of that particular company, which leads to a further increase in its share price. Shorts who were too late to act on this would end up facing huge losses. This is referred to as short squeezing.
Why are GameStop’s shares surging?
Gamestop Corp (GME) is an American video game, consumer electronics, and gaming merchandise retail-chain. The company had been struggling since 2016 due to stiff competition from online retailers. As we know, most games can be purchased and downloaded online. Amidst the Covid-19 pandemic, it faced huge losses last year. These factors led the company’s stock to crash. The share price of GME stood at $18.84 as of December 31.
Towards the beginning of January, several amateur day traders on a Reddit group –r/wallstreetbets– noticed that America’s top hedge funds were heavily short-selling the GME stock. The shorts included a big hedge fund- Melvin Capital Management LP. The Reddit group managed to convince other people on the thread to join forces and buy as much GameStop stock as possible. There were a lot of memes and posts circling through social media platforms, which made people aware of how they could bring down large hedge funds. These firms had been using the shorting method for ages and were benefiting from low-valued stocks.
This ultimately made the share prices go up astronomically. On January 28, GME’s stock touched an all-time high of $483! GameStop has secured its position in the Fortune500 list of companies, alongside Alphabet, Apple, Tesla, etc.
The coordinated attack eventually saw hedge funds facing losses of around $19 billion! It had even reached a point where some firms went bankrupt and had to close down. This encouraged investors to look into more stocks that had been shorted by large investment firms. Thus, the share prices of companies such as AMC Entertainment Holdings, BlackBerry, and Tootsie Roll Industries saw a similar rally. And, hedge funds were trapped in the short squeeze. The Reddit Group has also turned to Dogecoin, a cryptocurrency that was started as a joke. Last day, the value of Dogecoin surged 800% in 24 hours.
Melvin Capital, who had lost billions of dollars from the GME stock surge, was rescued by Citadel and Point72 Asset Management on Jan 25 (Monday). Both these hedge funds invested $2.75 billion into Melvin. A few days later, popular trading apps such as Robinhood restricted trading for stocks such as GameStop and AMC on their platforms. They only provided an option to sell these stocks, thereby preventing retail investors from purchasing more shares. The officials of NASDAQ (the exchange on which GME is listed) even suggested that trading could be temporarily halted on stocks that were targeted by ‘internet users’. All these factors led GME stock to fall to $231 on Jan 29 (Thursday).
Millions of people turned to social media platforms to show their dissent against Robinhood. They alleged that the broking app and large hedge funds were manipulating the stock market. Many people started questioning the motive behind the platform, which claimed to “democratize finance for all”. Interestingly, several reports started flying around, stating that $39 million of Robinhood’s revenues from equities and options order flow came from Citadel. This meant that Citadel is one of the largest customers of the trading platform. Thus, a connection between Robinhood, Melvin Capital, and Citadel was now clear.
If more solid evidence points to market manipulation, these companies would be in big trouble. The US House of Representatives has conducted discussions on the matter. Three lawmakers have called out an investigation into Robinhood’s actions. Two class-action lawsuits have been filed against the trading platform in New York and Illinois federal courts. The US President’s Office also put out a statement saying it was monitoring the situation.
On Thursday evening, Robinhood announced it was restoring “limited buys” for the restricted stocks, allowing fans of the stock to buy more. This led to a further rally in GME, AMC on Friday. The company also said it has raised $1 billion from its existing investors. The firm had been struggling to handle a surge in trading on the platform.
Now, you may be wondering if such a situation could occur in our Indian stock markets. We have been reading reports of several online forums such as ‘IndianStreetBets’, which aims to send Suzlon Energy’s stock “to the moon”. The group consisting of around 12,000+ members plans to pump up share prices through coordinated buying.
However, financial experts believe that such attempts at buying and holding stocks to trigger short squeezes in our Indian market would not produce any result. This is mainly because investors in India do not hold such large naked positions in an individual stock. The Securities and Exchange Board of India (SEBI) has also introduced several regulations that restrict the shorting of stocks. Traders are allowed to short a stock, but the position cannot be held for more than one trading session. This is why most traders and institutions in our country restrict their short positions to stocks that are part of the derivative segment. [Derivatives are securities that derive their value from an underlying asset or benchmark. Common derivatives include futures contracts, forwards, and options]. Even within the F&O segment, traders would have to pay a high price for holding short positions.
Nithin Kamath, the co-founder of Zerodha, recently posted a blog that gives us a clear idea of why a GameStop-like phenomenon would not happen in Indian stock markets. You can read it here. So long story short, we would not be able to drive up the prices of stocks like how our American counterparts did.
However, this whole situation has brought to light the wide disparity between large financial institutions and normal retail investors. Hedge funds have been constantly trying to outsmart their competitors and get away with billions of dollars from Wall Street. These same investment firms are crying foul over what has happened with GME shares. A market that was meant to be free is heavily influenced by large players. Let us look forward to seeing how this situation unfolds in the days to come.