Members of the “WallStreetBets” forum on Reddit, a social discourse website, created a bubble on the stocks of GameStop, a retail company for video games and electronics. This was done in an effort to get back at wealthy hedge funds that were shorting the company’s shares.
Shorting a stock refers to the practice of investors selling their shares at high prices with plans to buy them back at lower prices in the future, essentially betting on the stock to decrease in value.
The WallStreetBets forum has been active on Reddit for eight years, ballooning in popularity only as recently as 2020, collecting close to two million subscribers. Members of the group would identify certain stocks, such as Blackberry or American Multi-Cinema (AMC), which were being shorted by prominent hedge funds and investors on Wall Street, and decided it was time to flip the script.
Professor Leonard Brooks, director of the Master of Forensic Accounting program at the University of Toronto Mississauga, spoke to The Medium about how hedge funds make money through shorting stocks.
“Hedge funds, and others, had been in the habit of selling shares short, and doing it in a way that sometimes manipulated the price to the disadvantage of the retail investors out in the market,” stated Brooks. Essentially, hedge funds would sell their borrowed shares at a shortened price to incoming retail investors.
Brooks went on to explain how hedge funds drove down the share prices for retail investors by selling shares short.
“The hedge funds, quite understandably, chose companies that could effectively drive the price down,” he continued. “By selling high and buying low, they give the stock back to the people they borrow it from.”
This strategy is not new in the market and has been going on for decades. The problem, also identified by the subscribers of the WallStreetBets forum, is the sometimes-artificial driving down of the stocks by these investment titans.
“A stock can fall off because the business is over-valued, or because there is some negative news or rumours that come out,” explained Brooks. “Some hedge funds sometimes place stories that cause the stock to decrease…the retail investor would come cruising along and see these guys driving the price down.”
What happened in January was a collective effort of identifying certain stocks, which were being targeted by prominent hedge funds, and a mass purchase of shares by retail investors. This caused the stock price to increase and forced the hedge funds to purchase their borrowed stocks at higher prices, losing money on their short. One of the prominent players, Melvin Capital, reported a 53 per cent loss on their investments in January. Both Melvin Capital and Citron Research officially closed their short position on January 27.
On January 28, in response to the dramatic rise in GameStop share price, some trading platforms, including Robinhood, had announced restrictions on purchases of certain shares.
“Robinhood got a call around 3 a.m. from their clearinghouse, saying they had to put up enough money [to] do the transactions if these traders don’t follow through,” stated Brooks. “That request was over one to two billion dollars.”
Following increased pushback and concern on such limitations on trading, Robinhood had to lift the restrictions the very next day, allowing for the purchase of a limited number of the target stocks’ securities, still closely monitoring the situation.
The aftermath of the ordeal has resulted in more than an 80 per cent decrease in GameStop stock price. After closing at an all-time high of USD $33.7 billion on January 28, GameStop’s market value fell to USD $4.4 billion on February 5.
While the rollercoaster ride may be winding down for GameStop, the next big thing may be right around the corner for these players. But what does this kind of volatility mean for the average retail investor?
“If you were a retail investor who owned shares for quite a while, you would see that hedge funds selling shares would push the price down, and you wouldn’t know why,” stated Brooks. “But then you see that these other retail investors who came in, bought shares, and pushed the price up—which would be good for you. You again wouldn’t know why it [was] rising.”
Brooks argued that if a retail investor reviews the stock and is unable to come up with a reasonable explanation for its performance, they should probably sell their investment and get out.
“If the upward and downward pressure dissipates, it may come back to a reasonable level. For the person who wants to hold on for a reasonable investment, the volatility may be disturbing, but if they can hold on long enough, it’ll probably come back to where it should be,” continued Brooks. “Then the question is: Can people like you and I hang on through the volatility?”