An explanation of Reddit’s war with Wall Street institutions

January 27, 2021
Owen S. Good
Polygon

American stock markets are in a lather. Little-guy investors are supposedly cratering billion-dollar hedge funds. Reddit, social media, and now Elon Musk are involved. And somehow, this is all for GameStop, the beleaguered video games retailer notorious for giving gamers pennies on the dollar for their used software.

It’s very hard to recap what is going on with GME, the ticker symbol that has become a hashtag, because the news in a volatile stock market changes instant to instant. We’ll try anyway. The most important thing to understand about GameStop and short selling is that this is now a very high-stakes gambling table with theoretically infinite losses that, for some big players, are becoming very real.

So real, in fact, that President Biden’s economic team and U.S. Treasury Secretary Janet Yellen are “monitoring the situation,” White House press secretary Jen Psaki said Wednesday.

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WHY IS GAMESTOP’S STOCK PRICE SO HIGH?

GameStop’s share price, which closed on Tuesday at $147.98 (it’s gone over $300 today) isn’t any reflection of its health or value as a company. It’s a reflection of a war between “retail investors” (individual day traders, or regular people) and institutional investors (big Wall Street firms).

Hedge funds, supposedly the professionals, have been betting against GameStop’s stock using a trading technique called short selling. Day traders, organizing under the subreddit r/WallStreetBets, are holding onto the shares of GameStop that they own — despite skyrocketing values that have made some of them millions of dollars on paper — to stick it to the hedge funds.

The battle began in earnest last week, when r/WallStreetBets realized that its users, who had bought into the stock when the supposed smart money was shorting it, effectively controlled the supply of GameStop shares in circulation. Now the banks need to buy that stock to cover the obligations of the short-sell bet they have made. The Redditors are refusing to sell.

WHAT IS SHORT SELLING?

Here’s a very dumbed-down analogy that’s actually 100% accurate.

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The “group of apes” in this situation is a chaotic group of investors organized under the r/WallStreetBets subreddit, which counts more than 2 million subscribers. Last week, one of them realized that GameStop was in a “negative float” position. This means that the number of “shorted shares” — that is, the shares loaned to investors that must be eventually returned — was actually greater than the number of shares available to trade.

“There is likely not an original GameStop-issued share left on the market,” the user wrote. “[The] shares that you, me, and [another user] own are a shorted share. […] There is no way that [short sellers] can get themselves out of it. They’re only going to be buying back their shorted shares which, since they are above 100%, there is no way to do that, unless institutions sell off everything they own into the open market.”

In other words, the longer the folks at r/WallStreetBets hold onto their GameStop stock, the higher the price goes.

DOES GAMESTOP ITSELF HAVE ANYTHING TO DO WITH THIS?

No. The company’s last communication with investors was a Jan. 11 report on its 2020 holiday sales results (total sales down 3.1% from 2019, for those counting).

On the same day, however, GameStop announced that Ryan Cohen, a well-known investor who bought a 10% stake in the company last fall, had joined the board of directors, along with two of his allies. This caused the initial jump in GameStop’s share price, as Cohen in November wrote a scathing, get-your-stuff-together letter to the company’s board. Little-guy traders loved it, viewing Cohen as a savior. Investment banks thought their amateur counterparts were due for a bath, and bet accordingly.

DID A BILLION-DOLLAR HEDGE FUND ACTUALLY GO OUT OF BUSINESS OVER GAMESTOP?

No. But Melvin Capital, the fund in question, did take a huge loss when it closed out its short position (i.e., paid its bet and left the table), CNBC reported on Wednesday.

CNBC could not confirm the size of the loss Melvin Capital actually took, but noted that the company took on a $2.75 billion cash infusion from two investment banks to keep itself solvent. Gabe Plotkin, Melvin’s manager, told CNBC that speculation the hedge fund would file for bankruptcy is false.

HOW MUCH MONEY HAVE PEOPLE MADE?

Bear in mind that this is paper wealth (and it’s fluctuating wildly), but the trading on GameStop — by the way, on Tuesday it was the most-traded security in the world — has created about $2 billion in wealth, most of it for Cohen and the company’s two other biggest shareholders.

WallStreetBets Redditors, however, have bragged that their portfolios have skyrocketed into seven-figure territory. Realizing these gains, of course, would require someone to liquidate their shares. GameStop’s Cohen is, by definition, in this for the long haul — he bought in to shape the company’s direction, and would lose that power if he sold out. And the Redditors are holding onto their shares with reckless, YOLO glee, promising to see the stock price soar to the moon, Mars, or other celestial ports of call.

HOW DOES THIS END?

Short squeezes are a risk of short selling and one that institutional investors are prepared to face, but their assumptions are based on normal investor behavior, and what’s happening right now is anything but normal.

Usually, a share price would reach a too-good-to-refuse level, and there would be a run to cash in on it. While some people would make a lot of money, and others would lose big, the stock would return to a more normal reflection of the company’s true value and health.

But the “meme stock” punters of Reddit are refusing pretty much every offer. Moreover, they’re turning their attention to other shorted stocks where they can hurt investment bankers and hedge funds. (AMC Theatres, Blackberry, and Bed Bath & Beyond have become primary targets for WallStreetBets users hoping to force similar gains.)

Short positions of greater than 50% (that is, where more than half of a company’s tradable shares have been sold short and aren’t covered or closed out) are unusual. GameStop had more shares sold short than were actually in circulation, which is called “negative float.” Once WallStreetBets realized GameStop was in negative float (information that is easily obtainable), it started putting the screws to the short sellers by refusing to sell, putting the share price into a kind of positive feedback loop.

IS THIS LEGAL?

In a Bloomberg newsletter on Tuesday, Matt Levine wrote: “It might be illegal in all sorts of ways, but it is not obviously illegal, and if the U.S. Securities and Exchange Commission were to go after WallStreetBets for this stuff they will be breaking new ground and going beyond their previous cases.”

For now, it appears to be well within the rules, such that any exist in a dog-eat-dog capitalist market. That’s what’s driving a lot of the schadenfreude and popcorn-eating on social media.

As victims go, it would be hard to find ones less sympathetic than short sellers and hedge funds. A common theme here is mocking institutional investors for being beaten at their own shady game. There is a large lesson still to come about the broadening of access to financial markets. But for the layperson, the best advice probably came from the well-known games industry analyst Michael Pachter last week: Stay away.

“The smart money already got in, and probably got out,” Pachter told Ars Technica.

Questions Using Close Reading and Critical Thinking:

  1. The first section of an article should answer the questions “Who?” “What?” “When?” and “Where?” Identify the four W’s of this article. NOTE: The rest of the article provides details on the why and/or how.
  2. Does this article have any bias? Why or why not?
  3. What is “short selling”? Does this situation actually have anything to do with how well or poorly GameStop is doing as a company? Explain.
  4. What is the difference between a hedge fund and a day trader? Who appears to be getting the upper hand in this situation? Do day traders appear to be motivated more by money or making things difficult for hedge funds?
  5. How has the social media site Reddit influenced this situation? What is a “negative float” position?
  6. Is GameStop in control of any of this? Why or why not? Who is Ryan Cohen and what’s his role in all of this?
  7. What appears to have happened to the hedge fund Melvin Capital? Have “retail investors” really made any money here?
  8. Is this all legal? What does the Biden administration say it is doing about the situation? Why are so many “regular” people excited about what transpired? Is there still time to “get in on the action”?
  9. In your own words, summarize why the GameStop situation is so notable compared to other stock market trading news that we rarely hear much about.

Read the original article here: https://www.polygon.com/2021/1/27/22252600/gamestop-stock-gme-why-whats-happening-explain

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