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Investing Insights

GameStop, Hedge Funds and the “Short Squeeze”

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Jim Steel, CFA, CFP

GameStop, Hedge Funds and the "Short Squeeze"

by Jim Steel, CFA, CFP

January 30, 2021


Headlines this week were full of “David and Goliath” stories about “little” Reddit users taking down Wall Street “elite” hedge funds by driving shares of GameStop (and a few others) up by as much as 1,700%. 

I’ve had many questions from clients about this so I thought I would try to explain, in plain language, what has gone on. 

To be clear - what is going on isn’t investing.  

GameStop

At the root of this saga lies a stock called GameStop, a U.S. video game retailer. GameStop is probably best known for its EB Games outlets that can be found in retail malls. With changing consumer preferences and the global COVID-19 pandemic, the prospect for companies in this type of business became bleak. Indeed, GameStop which, at its peak traded as high as $60, was trading for less than $3 in April 2020. 

A number of large US hedge funds had been placing big bets on the demise of this company over the past few years. The bets they were placing were called “short sales”. A “short sale” is where you borrow a stock and sell it. You hope to buy it back later at a lower price, pocketing the difference. 

Reddit and WallStreetBets

Enter Reddit and WallStreetBets. Reddit is a website where users post content that is then voted up or down by other members. Posts are organized into user-created boards called “subreddits”.  One of these subreddits is WallStreetBets. It appears as if most members of WallStreetBets are younger people with a distaste for Wall Street and a desire to “stick it to the “elite”.

Group members of WallStreetBets banded together and promoted the idea of buying GameStop shares for the main purpose of driving up the price to hurt Wall Street short sellers. Most of the short sellers were large U.S. hedge funds. It appears to have worked.

What drives stock prices

The most important factor determining a stock price is the equalizing power of supply and demand. There are a lot of things affecting supply and demand of course, but for the purpose of this article I am not going down this rabbit hole.

It’s an auction

Most people have been to an auction (or seen one on TV). At an auction, a seller commissions the auction house to sell, say, a painting. Potential buyers attend the auction and bid on that painting if they want to buy it. If few people are interested in buying, the auctioneer drops the price until someone bites. The last bidder gets to buy at a low price.  However, if a lot of people want to buy the painting, a bidding war begins. The auctioneer keeps increasing the price until one last bidder is left. The last bidder gets to buy the painting, but at the higher price. 

In this example, supply and demand come into play in a very real way. If there are very few paintings available and a lot of buyers, demand outpaces supply and the price increases.  Sometimes the price can rise dramatically (think of Van Gogh’s selling for north of $80 million USD). 

Conversely, if there are a lot of paintings for sale at the auction and few interested buyers, supply outpaces demand and the price falls. Without enough interested buyers you might be able to get that Van Gogh for under $50 million!  

A stock is just like that painting

For stocks, potential buyers and sellers meet at a stock exchange. The stock exchange acts as the auction house where potential buyers bid on stocks that potential sellers currently own. If the buyers are eager to own the stock they bid up the price - just like the painting. The price continues to rise until a seller agrees to sell at that price.  

Conversely, if the buyers aren’t eager to own the stock, the seller is forced to lower their asking price. The price continues to fall until a buyer agrees to buy at that price.   

There are millions of people playing this game every minute of every day on every stock. This matching of supply and demand determines the price of the stock. 

What is Short Selling

Normally a person will buy a stock first and sell it later. But it is possible to do the reverse: sell a stock you do not own now and buy it back later. This is called “short selling”. 

To do this you must first borrow the stock from someone who currently owns it. When you do this you must “post margin”. This means you must post sufficient capital in your brokerage account to cover a portion of a potential loss. This is how brokerages protect themselves in case shorted stocks soar in value.  

Typically, a brokerage will require you to post 150% of the value of the stock you are shorting. For example, if you were to short $3,000 worth of stock you would be required to post $4,500 margin (i.e. the $3,000 from the sale plus an additional $1,500).

If the value of the shorted stock then rises to $10,000 your new margin becomes $15,000. Since you only have $4,500 in your account you will be required to add an additional $10,500 to your brokerage account in order to bring your total cash position up to the required $15,000. This is referred to as a “margin call”. 

If you don’t have the additional cash available, the brokerage will automatically close out the position and buy the shares back on your behalf. But wait - you have only $4,500 cash in the account. When the brokerage buys back the stock it costs $10,000. This results in you owing the brokerage $5,500. The brokerage will go after you for this loss, but if you can’t pay it, the brokerage is ultimately on the hook. If brokerages get too deep into these situations it can affect their ability operate. 

An example of Short Selling (ignoring margin requirements): 

Albert doesn’t own GameStop and doesn’t like the prospects for the company. He thinks the price is going to fall. Betty owns GameStop and thinks the opposite. Albert then borrows Betty’s shares and sells them in the hope of buying them back at a lower price later.

[In reality it isn’t actually Betty lending the shares, it is the brokerages doing this in the background. Betty likely has no knowledge that her shares are being loaned to anyone. These are the games brokerages play with your money behind the scenes.]

If Albert sells the borrowed shares for $60 and then buys them back for $3, he makes a $57 per share profit. Albert then returns the shares to Betty. However, if Albert sold the shares when they were at $3 and bought them back at $60, he would face a $57 loss on the transaction. 

This can be risky  

Betty can ask for her shares back at any time and Albert would be legally obligated to give them back - immediately. 

Let’s say Albert “shorted” 1,000 shares at $3. His proceeds from that sale would have been $3,000. Now, he is forced to buy back that stock at $60. This will cost him $60,000, netting him a $57,000 loss.  

GameStock traded for less than $3 and increased to more than $460 per share. Shorting 1,000 shares at $3 could have cost Albert $457,000! 

As should be obvious, shorting stocks isn’t really investing. It’s gambling.

The “Short Squeeze”

This occurs when short sellers are forced (“squeezed”) into buying back the shares. Continuing with the example, let’s say GameStop has risen from $3 to $60. Three things happen:  

Fist, current owners may want to sell their shares in order to cement their gains. This means the “shorts” (people with short positions in place) are “squeezed” into buying the shares back at prevailing prices in order to return the borrowed shares. This increases demand and drives prices up.  

Second, some “shorts” may panic at the amount of money they have lost and feel “squeezed” into buying back the shares at prevailing prices to avoid further losses. This increases demand for the stock and prices rise further. 

Third, the “shorts” will face margin calls. If an investor can’t post margin, the brokerage firm will close out the position. The investor is therefore “squeezed” into buying the shares back at prevailing prices. This also increases demand for the stock and causes prices to rise even further.  

It gets weirder 

It turns out you can “short” more shares than actually trade on the exchange. The percentage of shares shorted versus the shares outstanding is known as “short interest”. In these cases we say that “short interest” is greater than 100% 

How does this work? In the example above, Albert has borrowed shares from Betty and then then sold  those shares “short”. Of course, when Albert sells Betty’s shares, someone else buys them. Let’s call this person Connie. Connie has no idea the shares she now owns have been borrowed from Betty.  

Connie, the new owner of the shares, then lends those shares to Doug because he wants to sell them “short”. Doug then sells the shares to yet another person and this dizzying process continues. It seems crazy that this is allowed, but it is. 

In cases where there are more shares shorted than trade on the exchange there can be a cascading effect that causes the “short squeeze” to be amplified. Imagine a scenario where every person who shorted a stock is forced into buying back at the same time. This causes a massive increase in demand for the stock and the price rises accordingly.  

This is exactly what happened at GameStop.  Hedge funds that had shorted GameStop were forced into “short squeezes” as the share price rose. They had to buy back the shares at ever increasing prices to avoid further losses. 

What is a hedge fund and why did this happen?

A hedge fund is basically a black box investment fund that charges high fees and offers little transparency. Most hedge funds are only accessible to accredited (i.e. wealthy) investors and generally face less regulation than mutual funds. A common fee plan for a hedge fund is 2% plus 20% of any gains.  

Aside: Why anyone would invest in a hedge fund seems a mystery. The fees are high and returns have been dismal. The Credit Suisse ALLHedge Index tracks how well hedge funds have performed. Over the last 16 years this hedge fund index had generated a total cumulative return of 47.32%. Meanwhile, the S&P500 index generated a whopping 370.98%. https://lab.credit-suisse.com/#/en/index/SECT/SECT/performance 

Instead of investing in companies for the long run as most mutual funds do, hedge funds may place big bets using various strategies including short selling and programmed trading. Hedge funds have become known for their “take no prisoners” approach to investing and have come to epitomize the “elite” of Wall Street.   

WallStreetBets noticed that the “short interest” on GameStop was very high. They realized that most of the “shorts” were large U.S. hedge funds and that if they could somehow get the price of GameStop to rise quickly and dramatically, the hedge funds would be forced into “short squeezes”. If they were successful, the Wall Street “elites” would lose billions. [There are laws relating to the manipulation of stock process and regulators will be looking heavily at this in the days to come.] 

In order to get the stock price to rise it has been reported that an army of WallStreetBets users started buying shares. They also promoted other “little” people to buy shares in order to drive the price of GameStop up. Indeed, the price did rise. A lot. And some hedge funds lost billions. [They did the same for  options on GameStop shares which added to the price gain. Options are exchange-traded contracts which either force, or allow you to buy or sell a stock for a set price at a  point in the near future under certain circumstances. They are complicated and beyond the scope of this article.]

This continued to spread. Other companies, most notably AMC Entertainment (the movie theatre chain) and Blackberry, saw their share prices rise dramatically.  

While it is possible that a relatively large number of small investors can drive up the price of a stock, it is doubtful that WallStreetBets caused the price to rise as much as it did on its own. 

Instead, it seems likely that other hedge funds, which didn’t have short positions in GameStock, may have employed programmed trading strategies that amplified the stock price movements. Programmed trading uses computer-generated algorithms to trade baskets of stocks. They trade in large volumes and with high frequency. Once a program is running, stocks are automatically bought and sold based on the algorithm. Humans can only deactivate the strategies after the fact. These programs may have identified patterns in buying and selling based on the “little” purchases and bought shares alongside WallStreetBets traders. This would have amplified the stock price increases dramatically. No one knows for sure if this happened (since hedge funds are black boxes with little transparency or regulation). But if this turns out to be true, then WallStreetBets was able to pit hedge fund against hedge fund.   

The takeaway

Sometimes the “little” guy can win. But short selling is not investing. It’s gambling.  

Whether the “little” guy actually won is a question still up for debate. There were likely lots of “little” people who lost money buying and selling the price swings. There were also likely lots of hedge funds that made money in the aftermath. But eventually the short sellers will go away, the “little” guy will move on, and the shares should return to earth. But when that happens is anyone’s guess. And guessing isn’t a good investment strategy.


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