The GameStop Frenzy: Where Finance meets Psychology

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For the first time, the stock of a single, inconsequential company has sent Wall Street into panic

Imagine this - what if you could become a millionaire overnight?

For Anthony, a schoolteacher who invested $100,000 into GameStop a month ago, that dream was just within reach, until he absolutely blew it all. [i]

The Beauties of Shorting

For thrill seekers and veterans of the stock market, there is a less conventional way to make money. It’s bumpier, it’s riskier, it’s scarier, and it’s called short selling.

Let’s say I own 100 shares in Company X, each worth $2. Anthony – after having done a thorough analysis, taking a look at historical earnings, and listening to his gut – thinks that Company X is doomed to fail, and poised to decline in value.

He borrows the 100 shares from me, sells them immediately on the market, and waits. 2 agonizing days later, the price drops to $1. Relieved, he buys back the 100 shares for only $100, and returns them to me. Anthony just made $100 in profit, less any fees I charged him for borrowing my stock.

This is when short selling works, and large hedge funds have made a million-dollar business out of it. [ii] There is something inherently pleasing that investors find in betting on a company’s stock to decline, and combined with constant market fluctuation, shorting the market can be a lot of fun.

The Risk of Shorting

Let’s look at a new scenario.

Anthony just borrowed my 100 Company X shares. But instead of the share price dropping to $1:

Day 2: The price has increased to $3. Although he is a little concerned, it is nothing major. He did his research, and  is confident that the stock will eventually fall.

Day 3: The stock has now climbed to $4. Anthony’s starting to have serious doubts, but it should be fine. This is just a temporary irregularity.

Day 4: Still no, and the stock just went to $5. Panicking, he buys back the 100 Company X shares at $5 a share so that he may return them to me. Instead of making $100 in profit, he is $400 in debt, on top of the fees I charged him for borrowing my shares in the first place.

See the risk? There is no upper limit to how high the stock could climb. Which means that when you short a stock, your potential of loss is theoretically infinite.

GameStop: The Next Victim

Many of us had never heard of GameStop before January. Try and picture a Blockbuster that sells used video games, consoles and accessories. [iii] That’s essentially GameStop in a nutshell, and given what happened to Blockbuster, it is not very surprising that GameStop’s stock has been falling for 6 straight years. [iv]

Unfortunately, Melvin Capital picked up on this. As one of the most respected investment management firms, it took one look at GameStop and decided that it was a ripe victim for some serious shorting.

So they went ahead and shorted it by 130 percent. [v] Melvin started the year with $12.5 billion worth of assets under management [vi], and their GameStop short position would have netted them millions.

However, they didn’t count on r/wallstreetbets pulling the carpet out from under them.

r/wallstreetbets

Can you picture 1 in every 40 Americans standing in a giant room, talking about what stocks to invest in? With 8 million amateur investors[vii] discussing the financial markets 24/7, that is what this particular Reddit group is.

Upon finding out that Melvin Capital had basically condemned GameStop to the gutter, there was a collective outcry. These massive hedge funds, responsible for the 2007 financial crisis, who had sought billion-dollar bail outs from the government [viii], were poised to make a fortune betting against a quite, unassuming company. It was a massive blow to retailer investors everywhere.

With lower brokerage fees, higher trade volumes, and the ability to “co-operate” [ix], large hedge funds have a lot of control over the direction of the market. It is a product of their need to satisfy investors, and maximize returns that they have so much power and affluence. Unfortunately, the average investor is not so sympathetic. Combined with the frustration generated from the last economic crisis, Melvin Capital’s actions would have been another frustrating reality check.

GameStop was a breaking point, a way to finally condense and direct all this simmering anger at something. 2 weeks into 2021, wallstreetbets became a rallying place, and the scattered chatter of anonymous users grew more and more potent until the decision was made to do something.

In what has become the biggest coordinated effort by individual investors anywhere, the decision was made to purchase shares of GameStop. Thousands of people, fueled by anger, excitement and a sense of righteousness, finally decided to rise up together against Wall Street.

The Effect

No one could have predicted what happened next. In just 12 days, the share price of GameStop leapt up nearly 900% to reach a high of $347 by January 27th.[x] People were flabbergasted. Was it really just the frenzied purchases of retail investors that drove the price up this high?

Remember our lesson on the risks of short selling. Upon shorting GameStop, Melvin Capital theoretically stood to lose an infinite amount, because there is no limit to how high the price could climb. The fund managers, upon seeing what was going on, panicked.

They made the same mistake that Anthony made in our example. They saw the price steadily rise, and scoffed, thinking that it was an anomaly, a hindrance that would eventually stop. After all, Melvin Capital was a well-respected name in shorting the market, and there was no way that their research was faulty.

Contrary to that wishful thinking however, Melvin watched with increasing unease as the price went higher and higher. With mounting pressures from the brokerages who lent them shares, they had no choice but to go back and buy the shares at extraordinary high prices to cover their positions, and return the shares to their brokers.

Melvin Capital lost 53% of its assets in January trying to cover its short position. Across social media platforms everywhere, wallstreetbets was being praised for its actions. The average person was making huge profits holding onto GameStop while creating a sizeable dent in Wall Street. In theory, the share prices may have gone up for weeks more, delivering vindication to a thousand more retail investors.

Unfortunately, the Robinhood platform which had for weeks facilitated this massive trading succumbed to pressure from hedge funds, and placed a firm cap on amateur traders.

On January 28th, at the peak of the frenzy, Robinhood halted trading of GameStop.[xi] People could still sell, but individuals were restricted from buying more shares of the company. The price started falling, and people who had made thousands holding onto GameStop saw their portfolios rapidly declining in value.

Of course, the fall in price sent investors into a greater panic, prompting the sale of more shares and sending GameStop tumbling even further in value. People tried to hold onto whatever gains they had made, and cries from the wallstreetbets to stand fast and hold did little to help.

That is ultimately how people like Anthony, whose portfolio was worth over $1 million on January 27th, saw his investment fall by 90% in a matter of days.

A Look at the Future

This entire debacle has got a lot of attention, but largely for short-term reasons. While covering the financial losses and legal proceedings of this event is definitely important, it is worthwhile to look at the psychological preconditions that set the stage for the GameStop rise, and the implications going forward.

Large hedge funds used to be able to control the market because they had better access to information, more assets under management and more qualified investors. However, the GameStop rise demonstrates how technology is starting to turn the tables, slowly eliminating the advantage that the big players have.

Without a doubt, a company’s primary responsibility is always to its shareholders, and Melvin Capital simply acted in the best interests of its beneficiaries. On the other hand, people are no longer content with being overshadowed by large corporations, especially when those corporations have the power to single-handedly determine market trends.

This is the first time in history that 8 million amateur investors were able to collaborate and wreak havoc upon a major corporation, and it is a direct result of the increased access to learning we collectively have a society.

GameStop wasn’t just a one-time fad that can be seen as a stock market anomaly. It is a marked depiction of what happens when retail investors get tired of being second class traders to big hedge funds, and annoyed with them calling all the shots (and shorts) on the market.

The financial services industry would do well to take this incident under advisement. The only way for corporations and individuals to coexists in a mutually beneficial capacity going forward, is if individuals are provided opportunities to make their voices heard and enact real change on issues that matter to them. Simultaneously, big businesses need to start being more open to corporate social responsibility initiatives in order to improve public perception, and thus avoid public pushback that can result in costly damages, in terms of both money and perception.

Sources


[i] https://www.vice.com/en/article/g5b354/this-whole-thing-has-numbed-me-to-money-gamestop-investors-after-the-crash

[ii] https://www.bloomberg.com/news/articles/2021-01-27/reddit-jolts-activist-short-hedge-funds-into-adapt-or-die-mode

[iii] https://www.gamestop.com/INTL/choose_site_ca.html

[iv] https://www.cbc.ca/news/business/gamestop-wednesday-1.5889652

[v] https://www.institutionalinvestor.com/article/b1qm7508qzvkhd/Melvin-Capital-Added-to-GameStop-Shorts-as-WallStreetBets-Took-Aim#:~:text=Melvin%20shorted%20an%20additional%20600%2C000,in%20the%20Wall%20Street%20Journal.

[vi] https://www.reuters.com/article/us-retail-trading-melvin-idUSKBN2A00KW

[vii] https://www.vox.com/the-goods/22264303/wallstreetbets-reddit-gamestop-stocks-language-community

[viii]https://www.investopedia.com/articles/economics/08/government-financial-bailout.asp

[ix] https://www.cnbc.com/2015/06/05/activist-hedge-funds-shrug-off-sec-collusion-inquiry.html

[x] https://www.ctvnews.ca/business/in-battle-over-gamestop-shares-two-big-players-flinch-1.5284114

[xi] https://www.valuethemarkets.com/2021/03/04/robinhood-ipo-gamestop-trading/

More posts by Vanit Shah.
The GameStop Frenzy: Where Finance meets Psychology
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