Did the GameStop frenzy stick it to Hedge Funds?
GameStop: you’re probably aware of the recent media frenzy, over how a bunch of Redditors, stuck it to a bunch of hedge funds, and in the process saved a company from the verge of destruction, right? Well, in this article, we will explore how they did this. Was it successful? Was it legal?
How they did this?
The story goes; an obscure subreddit (online community forum), called WallStreetBets, found that there had been many ‘short option contracts’ placed on the GameStop stock.
What is a short option contract? A short option is when someone or an institution, for whatever reason, predicts that the price of a stock/share/currency/commodity is going to go down or become cheaper in the future (or they want to make it cheaper, but we’ll get to that later), so they borrow the share/stock/currency/commodity, from someone that has it, to sell it at a higher price, with the expectation that they can buy it back when it’s cheaper. They can then return the shares they bought cheaper to replace the ones they borrowed, before the contract to return them expires, pocketing the difference from the sale at the high and the purchase at the low. However, when you sell too much of one thing, say you ‘dump it on the market’, you create a lot of supply. If there’s nobody there to buy it, then the price ultimately goes down, as the person placing the short contract would have expected.
However, with GameStop, this was not the case; the price of GameStop didn’t go down, a flurry of Redditors and YouTubers noticed the short options that were placed and decided to create the demand needed to buy up all the shares, driving the price up instead of down. Pushing the price of GameStop shares from $17 on the 5th of January, to $347 just 22 days later, eventually reaching a high of $450 in the same trading day. A phenomenal increase of over 2,000% in 22 days. When the short contracts expired, people who took out the short positions (mainly hedge funds) had to buy back the stock they borrowed, at a huge premium. This is what’s called a ‘short squeeze’ and is what happens when demand pushes the price up, causing losses to people who had shorts in place and squeezing them out of any profits they were looking to make before they had the chance to return them at the end of their contract.
Hedge Funds are entities, with capital, that seek out shorts; they ‘hedge’ against the success of something, this could be a national currency, company stocks or even house prices. In this case, one such hedge fund, Melvin Capital sought a $2.75 billion dollar emergency cash injection after their GameStop contracts expired, due to being forced to buy back the GameStop shares at a huge premium. Ouch.
So, was it successful?
In short not really, despite the fact that Melvin Capital lost around 50% of its value, it’s hard to argue that this hurt many other big financial institutions. At the time of writing (04/02/2021) GameStop shares are currently trading at $66, a decline of -$384 from a $450 high. What’s worse is that it might have hurt retail investors, people like you and me, but we’ll explore that later.
Why did the price fall faster than it rose? The first reason is fundamentals; GameStop as a company has had a rough year. Its main revenue stream is selling used games through physical stores, but thanks to Covid19 and the growth of online game purchases, that revenue stream was dry for 2020. The billion-dollar, fortune 500 company status that a share price of $450 entails just isn’t justifiable for a company that has been operating at a loss; one that is probably is past its hay day. Investing in GameStop now is like investing in Blockbuster after they rejected an offer to buy Netflix for $1 Billion.
The second reason is because of greed: for the price to stay high, there needs to be a lot of demand and not enough supply. A number of large shareholders, like the founders, and people that had bought shares in at under $100, naturally would have taken profits all the way up to $450, increasing the supply of shares, and making room for new shorts to be placed.
But lots of people that had just received a $600-$2000 US government stimulus check had watched the news and seen that investing in GameStop or other companies on the Wall Street Bets Reddit page, had the potential to make them 1000% in a month, might have been drawn into the idea. WallStreetBets saw 8 million new members in January. Most of them were unaware that an overpriced stock was probably not going to be a bad thing for the majority of short-sellers, -especially when it involves a fundamentally unprofitable company like GameStop.
Inflating the price and overbuying a stock, gives hedge funds a bigger opportunity as there is more room for bigger short positions and higher profits. And that’s what happened.
Was it legal?
I can currently think of two legal contentions regarding this whole saga. Firstly, were Redditors practising insider trading? And was the trading platform Robin Hood doing something unlawful by restricting its users from buying GameStop on their platform?
Stock prices are designed to fluctuate according to supply and demand. Any misrepresenting signals to potential investors that do not reflect this natural relationship could be an act of market manipulation. Section 9(a) of the Securities Exchange Act 1934 gives the core definition of market manipulation as using means such as emails or other to create 'a false or misleading appearance of active trading.' Different types of manipulation fall within section 9's scope, but one is more likely to be relevant here. What is known as 'pump & dump', is creating artificial inflation (pump) to the stock price, only to sell it (dump) when it has reached a desirable price point. Once the stocks are dumped, the stock price dives much in the same way the GameStock did, within a matter of a trading day. This is usually done with close-to-worthless stocks, many times of companies that are in decline (such as GameStop).
Typically, the US Securities and Exchange Commission (SEC) goes after pump & dump cases with a mix of two things: where fake news or generally false information were distributed with an aim to hype up or down a stock price, and where these created the impression that many are buying (or selling) the stock. Social media and other mainstream websites play a big role here because they are the go-to outlets of fake news and generally misleading information about the stock market. GameStop was not the first company whose stock price didn't reflect its real value at some point. For example, in 2015 SEC went after 3 'penny stock promoters' (promoters who are hired or make a profit out of commenting on specific stocks) for distributing (false) information online that investing a particular stock would yield big-time profits.
However, as you might have guessed, this is not precisely the case of the 8+ mil followers of WallStreetBet or Keith Gill aka Roaring Kitty, who runs a YouTube channel and has been obsessing over GameStop for the better part of 2020 (also pointed by many as the starting point behind the stock frenzy). Was the WallStreetBet a 'pump & dump'? Technically, sharing opinions about stock prices is not what's wrong. According to an insider, it's usual for hedge fund managers to exchange views on stocks in 'idea dinners' – exclusive meetings where insights and who knows what other information is put on the table. So, given grouping is not that all unfamiliar to regulators, where do the millions of WallStreetBet fall?
What's unique here is that no single person is orchestrating the entire thing, so it is impossible to pinpoint one person responsible. Wouldn't holding accountable 'influencers' for stating opinions be, in fact, contrary to free speech? Of course, the GameStop stock did not remotely connect to the business's actual valuation. However, it's shaky to argue that there was no real demand for it, considering the millions who bought the share, and the often-ridiculous reasons people buy shares. The catalyst factor seems to be intent; were the individuals aware of what was happening (and intended to sell when the stock price got to the tip of the iceberg), or were they investing for the long-haul? It appears that Roaring Kitty was actually in the second batch, who claims not to have sold off his stocks when the GameStock was still in heavens, and as a result to have lost more than $13m. This shows some dedication to GameStop and the actual belief that the organisation would turn around for real. I guess we'll find out in Roaring Kitty's answers to the Congress' questions. The case might prove trickier for Redditors who had specifically urged others to buy to drive the price up and 'stick it to the hedge funds.' Time will tell. Till then, it's Robin Hood that's under fire.