Why is everyone talking about the GameStop Wall Street Bets Reddit thread?
The actions of a group of investors has sent the stock market into what can only be described as a frenzy. What began as a mere comment on a Reddit thread soon became a central game piece in a financial power struggle between Wall Street investment firm giants, such as Melvin Capital, and a group of Robin Hood inspired stock traders. The battle over the GameStop shares has been significantly increased by its notoriety on social media, with the likes of Elon Musk adding fuel to the fire. The group of investors who have waged a trading war against Wall Street had created a subreddit group, Wall Street Bets, which has grown from a few hundred thousand to approximately 3.9 million users, to encourage everyday investors to take profit from the professional Wall Street giants in what has become possibly the largest short-squeeze in history. A short squeeze occurs when a stock or other asset peaks sharply forcing traders who had bet that its price would fall to buy it in order to forestall even greater losses. Their scramble to buy only adds to the upward pressure on the stock’s price and continues to inflate its value far beyond its market worth.
The war on trading began when investors started to anticipate the financial decline of an in-store video game retailer, GameStop, as the current climate has made it increasingly difficult for companies without an online presence to survive. Due to this, GameStop became the subject of what is known as short selling in which professional investors borrow shares of stock and sell it at market price anticipating it to decrease in value; they will then buy the stock back for a lower price than they sold it for to return to the lenders and make a profit from the difference. However, an element of what exacerbated this difficulty was that Melvin Capital over-shorted the stock by fronting more than was actually available. As of the 26th of January, Melvin Capital have lost approximately $3 billion.
Let’s explore an example of how this mechanism of ‘short-selling’ works:
If an investor believes that company X is struggling financially and its shares are overvalued at £550 a share and that it will depreciate in the near future, the investor could borrow 10 shares from a broker, and then sell these shares at their current market price to a third party entering a contract to purchase them back. If the stock then does indeed depreciate in value to £400 per share then the investor will purchase it back for lower than the price for which they sold it and then return this stock to the lender. In this scenario, it would provide a difference of £150 profit per share, which if you borrowed 10 shares would accumulate to £1,500.
Essentially, short selling is a way to make a lucrative profit by betting against a company as it is more common for stocks to rapidly depreciate than appreciate in value. Speculative investors will short sell to capitalise on the profit difference by purchasing shares for less than they sold them for. Professional investors such as hedge fund firms will short sell to protect gains or to minimise their losses.
As the subreddit group Wall Street Bets went viral for their involvement with the GameStop stock, more people invested in this stock, and the social media hype significantly overinflated the value of these stocks from their initial offering in December 2020 $20.99 USD to the beginning of its notoriety on the 14th of January $39.91, to its value on the 28th of January of $347.51 per share. This is an increase of 870.7% this month alone.
What will happen?
It is extremely likely that this GameStop scandal will follow a similar pattern as the 2008 Volkswagen short squeeze scandal. Frankfurt Reuters and Volkswagen briefly became the world’s biggest company by market value as stock price increased from €210.85 to over €1000 in a matter of days. Therefore, short sellers were caught betting on the depreciation with borrowed stock and frantically sought-out shares to minimise their losses. However, due to the borrowed stock being far over the amount of shares actually in existence for purchase, many investors could not exit their position and so lost extensive amounts of money in the market crash.
It is easy to become swept away in the success of a stock market increase and especially for those everyday investors who have made a significant profit on the GameStop stock increase scandal. It is crucial in any investment, but especially when trading with temperamental stocks and shares, to ensure that investors only invest what they can afford to lose. Particularly with the case at hand, short-selling is arguably one of the riskiest types of investment as theoretically there is no limit on the monetary loss, shares could increase for an infinite amount of time. With the price per share already valuing at an 870.7% increase and with the social media notoriety of this trading war with Wall Street firm Melvin Capital, the inflation of the stock value to far above its market worth is a significant risk for these Wall Street giants. Once these main shareholders who have overinflated the stock decide to discretely exit by selling their positions, the fear of uncertainty and doubt (‘FUD’) caused by this sudden shift will leave many unable to sell their shares. Ultimately, this would result in a market crash. Governmental regulatory bodies, such as the Securities and Exchange Commission (SEC), have released statements indicative of an ongoing investigation and close monitoring of the situation. It is well within their discretionary power to freeze trading on this market and the degree or direction of their involvement and how this will affect the stock is unknown. A former lawyer of the SEC has warned that volatile trading, fuelled by opinion with virtually no corporate activity to justify this increase in value, is exactly what SEC investigations are made of.
In light of this, we would warn that the degree of risk involved in this stock market has created, what may only be perceived as, a price bubble.