The GameStop Saga

Sam Swift, CFA, CFP®, AIF®

Feb 2, 2021

If you’ve followed the financial news at all this week, you’ve surely read stories about the meteoric rise in GameStop’s price. It’s been a long while since I’ve seen this much discussion about one stock, so let’s get into it.

What’s Going On?

GameStop, as you likely know, if you’ve ever walked through a mall, is a retail outlet that sells video games and consumer electronics across multiple countries. It started the year priced around $19 per share. In just the last two weeks, the price has risen to nearly $500 per share in intraday trading! What is happening is a “short squeeze.” This isn’t a rare phenomenon, but the mechanics by which this one is happening are. First, what is a “short squeeze?”

Most investors buy stocks in a straightforward way—they purchase shares with the idea that they will increase in value over time. This is called the “long” position. Some investors choose to take the opposite side, however, and bet on a stock going down. In order to do this they enter into a “short” position.

Let’s say I want to short XYZ company while it’s trading at $20. To do so, I technically borrow XYZ shares from my broker or trading desk and immediately sell them. Thus, I end up with $20 in my pocket for each share I sold. However, I have to return those shares to my broker at some point. My hope would be that the stock price would go down and I can repurchase the shares on the market at, say, $15 and return them to my broker. Thus, I make $5 in profit for each share I shorted, minus some interest that my broker charged me. Depending on the stock, this interest charge can be negligible or significant. Stocks that very few are shorting probably come with a low interest rate because they are easy to borrow. Stocks that many want to short probably come with high interest rates as the supply of stocks to borrow is low.

The problem for my short position, of course, comes if XYZ company goes up in price. Now I have to buy the shares back for more than I sold them and I will be out the difference. In theory, my losses are unlimited as there is no ceiling on how high a stock price can go.

In a short squeeze, typically you will have large short positions. If the price of that stock rises, all those with short positions are obligated to “cover” their positions at some point by buying the stock back at the higher prices. If there are large enough short positions out there, this creates a cycle where demand to buy the stock and cover shorts continues to drive the price even higher. It becomes self-reinforcing. That’s what we’ve seen with GameStop this last week.

Typically, this happens on smaller scales and between different hedge funds and institutional investors. What makes this time unique is that the short squeeze appears to have been initiated by a collective group of retail investors, specifically those on the Reddit forum Wall Street Bets (don’t ask me to explain Reddit).

Reasons for Concern

I have personally enjoyed watching this from the sideline. The idea of large hedge funds suffering huge losses from their short positions (where they should have known the risks) is pure schadenfreude. There’s a lot to be said about “market tough guys” immediately begging for help and crying foul when they experience the downside of the risks they were taking, but I’ll save that for another time.

I do have two major concerns about the perception among otherwise reasonable investors that can come with stories like this.

This Seems Easy

Some will, unfortunately, look at this and think how easy it must be. “Let’s just find those heavily shorted companies and buy them up to force a short squeeze.” Indeed, the Redditors are already on to a few other stocks, notably Nokia, AMC Theaters, and even the holding company responsible for the liquidation of Blockbuster. As a child of the 90s, I didn’t think I’d see the companies of my youth return with such a bang, but here we are!

The problem with this is that it isn’t just that easy and it certainly won’t be going forward after short sellers take note of what happened here. It takes a lot of capital for a short squeeze and there’s no guarantee it happens. Depending on when you get in on the game, you could be holding huge losses. There will be many that jump on the bandwagon at ridiculously high prices and end up losing a lot.

What’s the worst thing that can happen to you during your first trip to a casino? You win. You start to think it’s easy and you bet bigger and lose more the next time around.

I fear the same thing could happen here to the next generation of savers. They’ll look for the home run investments instead of recognizing the opportunity they have by just focusing on saving over the long-term into a diversified portfolio.

This Seems Rigged

Stories like the GameStop saga can lead to people losing faith in stock markets and, thus, the wealth they can help build over the long haul. I will disagree strongly that “rigged” is an appropriate word, but you’ll find no argument from me disputing that the stock market appears to be a casino on a day-to-day basis. It pretty much is! But day-to-day isn’t what we’re interested in to achieve our goals.

We speak of market prices being “fair” at any given moment. That still remains true, but the definition of “fair” is that two parties have agreed to transact at a certain price. It does not mean that at any given point a stock’s price is an accurate representation of the fundamental value of that company in the short-term. Over the long-term, prices to tend to accurately represent a company’s stock price. GameStop stock will come down to a more reasonable estimate of its fundamental value—it’s just a matter of when. As short sellers have found out, their bet may be “right,” but they can’t remain solvent long enough to see it pay off.

GameStop represents about 1/5000th of the investable world market at its recent highest price. These last two weeks are just noise! Similar incidents happen all the time, but largely go unnoticed. Having a long-term, globally diversified portfolio is essentially our slice of the world’s productivity and economic growth. Nothing about the GameStop saga changes that fundamental truth.

There are a lot of interesting questions about the GameStop saga that need to be explored. For example, how and why do some exchanges decide to halt trading? How can a stock end up with more short positions than available stock? But the one easy question to answer is, “how should this change my financial plan?” It shouldn’t.

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