Amid the COVID-19 global pandemic, U.S financial markets saw an explosion of retail trading activity as individual investors fell in love with the world of stocks. Popular brokerage apps such as Robinhood, E-Trade, and TD Ameritrade empowered retail traders, giving them a voice in a marketplace that billion-dollar trading firms primarily dominated. The “little guys” were finally equipped with the necessary tools to compete with reputable hedge funds. This newfound power ultimately led to an unprecedented chain of events that almost brought the traditional financial world to its knees.

GameStop was a crippled video-game retailer that struggled in adapting its business model to meet the demands of a technology-driven world. Its primary revenue source is built around sales of physical game CDs, video game hardware, and console accessories. This type of business suffered as people began downloading their video games digitally instead of purchasing hardcopies in-store. The Covid-19 pandemic brought even more hardship as people were not allowed to shop at physical retailers for quite some time.

These factors made GameStop a prime target for hedge fund giants, especially those who looked to profit from the collapse of companies. Firms such as Melvin Capital decided to short-sell GameStop’s stock, hoping that the price would fall even lower than its current levels.

Short selling is a market mechanism that allows traders to profit if a stock price falls. To clarify how it works, I will explain it using the example of baseball cards. Let us imagine your friend owns a collection of antique baseball cards that is currently worth $1,000. You have convinced him to let you borrow his baseball cards, with the promise of returning them in a few weeks. Based on your insight, you have concluded that the value of the cards will soon fall, so you decide to sell them right away for $1,000. Now you have $1,000, great! However, you still owe your friend his cards back. About a week goes by, and you meet someone that has agreed to sell the same card collection for $500, which you buy on the spot. You can now return the card collection to your friend while walking away with $500 in profit from the entire process.

Still, short-selling presents dangerous risks if the trend does not go the way you anticipate. Suppose the opposite occurs. The cards jump in value to $2,000, and your friend demands his cards back.  You are now required to spend $2,000 to return his cards, even though you only received $1,000 from the initial sale. This transaction resulted in a loss of $1,000.

Hedge funds such as Melvin Capital chose to short GameStop’s stock because they believed the retailer was not fundamentally worth the price it traded at. This seemed like a sound decision until a group of speculative traders from the Reddit community, “wallstreetbets” found out about the hedge fund’s short position through its SEC filings.

In an attempt to spoil Melvin Capital’s negative play on GameStop, “wallstreetbets” rallied an army of traders and encouraged them to buy the stock. Massive amounts of buy orders flooded the market, which resulted in GameStop’s stock catapulting to unforeseen levels. The higher the price went, the more money Melvin Capital and other hedge funds lost in their short position. The short squeeze ignited by Reddit’s fearless trading community caused Melvin Capital a loss of 53% in January 2021, as they were forced to close their short positions. Brokerage firms also scrambled to harvest enough capital for their operations to stay afloat.

In a shocking turn of events, Wall Street titans found themselves succumbing to the everyday retail traders. Some day traders were able to pocket millions from the chaos as they rode the momentum of GameStop’s stock to a record-high $483 per share. This historic moment forced Wall Street to pay attention to Main Street like never before. No longer can they underestimate the power of the individual investor, or else they may end up beaten at their own game.

References:

https://edition.cnn.com/2021/01/31/investing/melvin-capital-reddit-gamestop/index.html

https://www.ft.com/content/8be64f49-7c90-4fae-8370-c5c5c96d812c

https://www.bloomberg.com/opinion/articles/2021-01-27/gamestop-short-squeeze-is-rage-against-the-financial-machine

https://www.washingtonpost.com/business/2021/02/01/gamestop-retail-stores/

https://www.cnbc.com/2021/01/31/melvin-capital-lost-more-than-50percent-after-betting-against-gamestop-wsj.html

https://edition.cnn.com/2021/01/29/investing/wallstreetbets-reddit-culture/index.html

https://www.bbc.com/news/newsbeat-55841719

https://www.cnbc.com/2020/10/10/why-gamestop-declined-as-video-games-boomed.html

https://www.cnbc.com/2021/02/01/these-two-indicators-could-determine-whether-the-gamestop-rally-is-near-its-end.html

https://www.cnbc.com/2020/10/07/how-robinhood-and-covid-introduced-millions-to-the-stock-market.html