r/WallStreetBets Stonks

All the things you wanted to know about Gamestop and all of the things you didn’t.

To understand how the GameStop stock (GME) explosion happened, we need to first understand a little about r/WallStreetBets (WSB), the subreddit that describes itself as being “like 4chan met a Bloomberg terminal.” WSB is filled with a wide variety of people. Some work in finance and want to manage a personal portfolio, some are kids with too much money who like to play expensive games, and some are looking to nurse a gambling addiction that’s been neglected since COVID canceled many sporting events. Generally, people on WSB are looking to trade stocks and make money doing it. WSB is able to exist largely because of the rise of no-fees stock brokers like Robinhood who lower the barrier to entry for stock-trading. You no longer need to have money beyond what you intend to invest, you just need a little bit of capital and the financial savvy. While WSB traders, known on the site as “degenerates,” have to provide their own capital, the subreddit is able to provide investing advice. On WSB, community members with experience and knowledge regarding stock trading make “Do Diligence” or “DD” posts where they share their financial research and speculation with the broader community. These posts can be massive, and go over the nitty-gritty of the finances of publicly traded businesses that WSB traders might want to invest in.

The first whispers of investment in GameStop’s stock came from a WSB trader named Keith Gill, known as u/DeepFuckingValue on Reddit and Roaring Kitty on YouTube. On July 27, 2020, Gill posted a DD to WSB in the form of an hour long YouTube video detailing why he was investing in GME. The video goes into amazing detail on recent changes to GME’s organizational strategy and future prospects, culminating in Gill explaining why he expects some modest growth out of GME. He suggested buying options in GME, expecting the stock to go from $4 in July to $8 by the end of January.

Momentum in stock trading describes a phenomena wherein short term increases in the price of a stock lead to further increases in the stock’s price in the absence of a fundamental cause for said price change.
— Assistant Professor Tristan Nighswander

In September 2020, a WSB trader going by u/player869 made a post titled “Bankrupting Institutional Investors for Dummies, ft GameStop.” GME had been a controversial stock on WSB, and it turned out Gill was wrong about their increases. Where Gill had expected $8 by January 2021, GME hit $9.47 in September 2020. This was a great return for Gill, but was not even close to the eruption of GME that was to come months later. u/player869’s post was in many ways similar to Gill’s DD, but u/player869 was the first to make an interesting observation: hedge funds were taking huge short positions against GME. “Here is the real kicker. GameStop’s short float. 120% has never been seen before. … When the stock hits roughly $15, we can expect to see… a fucking massive short squeeze.”

Before we continue with GME, let’s take a minute to understand what short positions and short squeezes are. When an investor shorts a stock, they borrow a share from a stock broker, agreeing to give the share back some time in the future. After borrowing the stock, the trader immediately sells it. At some point in the future, they’ll have to buy a share of that stock to settle their debt with the broker. If the stock price falls between when the investor sold the share and bought a new one to give to the broker, the investor gets to pocket the difference. If the investor is wrong and the stock price rises, then they have to buy a stock for more than they originally sold it for. If a stock price rises unexpectedly and investors don’t close their short positions (buy stocks and settle their debt with their brokers) fast enough, they will all have to buy stocks at a much higher price than they originally bought them. This increases the value of the stocks, causing more investors to close their short positions, causing a further increase. This feedback loop can cause a stock price to skyrocket quickly, putting investors who shorted the stock at a massive loss. That’s the short squeeze.

But why should investors buying back stock cause such a dramatic increase in stock price? In a short squeeze, the original increase in the stock’s value is rather small and it usually represents only a small change in the actual earnings or prospects of a company. This shows a separation in two types of value a stock can have: fundamental value and momentum. Assistant Professor of Economics Tristan Nighswander breaks down the two for us: “Fundamental value of a stock is a reflection of the value of the underlying company. If the company makes more sales or has new prospects for growth, share price should increase. If the company is in a dying industry, is poorly managed, or is losing out to competitors, the share price should decrease.” But beyond just being the earnings of the company, fundamental value also reflects that company’s future prospects. “If a company is young and poised for growth (think electric vehicle companies, meat alternatives, cloud computing), the fundamental valuation may be a very high multiple of current price per share above earnings as current earnings don’t reflect long run revenue potential, and for more mature companies (established automakers, brick and mortar retail, banking), the fundamental value is a low multiple of earnings as large growth spurts are unlikely for these companies.” Keith Gill’s Do Diligence post is an analysis of the fundamental value of GME, looking at what it’s future prospects could be, and how those prospects should inform our evaluation of GME’s value. “This ‘fundamental’ fair price is a theoretical construct, so precise fundamental values are difficult to pin down, but there is broad consensus regarding what might change fundamental valuation: Fundamental value increases if firms become more profitable, find new markets to scale operations, or invent new products which drive demand.”

Illustration by Mychal J. Miller

Illustration by Mychal J. Miller

But Nighswander also reminds, “Fundamental changes are NOT, however, the only reason stock prices change. Momentum in stock trading describes a phenomena wherein short term increases in the price of a stock lead to further increases in the stock’s price in the absence of a fundamental cause for said price change. This is both an empirical phenomena (stocks with above market returns over the previous few months tend to have above market returns over the next few months) and a logical result of the forces of supply and demand. As in a typical product market, if demand increases relative to supply, price will rise. Thus, if a stock performs well and this attracts momentum traders, the act of purchasing said stock further drives up the price, leading to even higher returns and creating momentum in the underlying stock price.” This momentum is what causes the short squeeze, and is what u/player869 was speculating about. He thought that, because of the increased demand during the short squeeze, GME would gain momentum that would far outstrip its fundamental value, giving a big return for anyone who went “long,” or bet for GME by investing in it.

In late January, the hype for GME stocks in the WSB subreddit had shifted from a belief in GME’s fundamental value to a plan to increase its momentum by all investing in GME at once. By giving GME’s momentum a boost, the WSB traders were able to hit the critical mass necessary to start the short squeeze, skyrocketing prices.

Short squeezes happen often, but what makes GME’s so noteworthy? First of all, short squeezes are often triggered by unexpected changes to a stock’s fundamental value. In 2008, hedge funds had taken big short positions against Volkswagen, but when Porsche acquired Volkswagen, it increased Volkswagen’s fundamental value, triggering a short squeeze that temporarily put Volkswagen as the most valuable company in the world. There are cases of short squeezes happening purposefully, but the only people who usually have the money to cause a bump in the market big enough are billionaires. Back in 2013, some really rich dude named Billy CEO of Pershing Square Capital Management, William Albert Ackman took a short position against a company called Herbalife. He claimed they were a pyramid scheme and destined to collapse. Another really rich dude named Dan Hedge fund manager Daniel S. Leob didn’t like what statements like that could do to Herbalife’s market value, so he announced that he had made massive investments in Herbalife, signaling he had faith in the company’s growth. Watching these two duke it out was an even richer guy named Carl controlling shareholder of Icahn Enterprises, Carl Celian Icahn. Icahn, to say the least, did not like Ackman. Icahn bought up hundreds of millions dollars of Herbalife shares just to screw over Ackman’s short positions. Icahn won five years later; in 2019 Ackman closed his short position on Herbalife, losing almost a billion dollars. GME is the first time a short squeeze has happened not because of feuding billionaires, not because of an unexpected increase in fundamental value, but because a large amount of random people figured out a way to game the system.

Whether that’s driven by reddit and stonk memes, hedge funds, or billionaires I don’t know, but I’m sure this won’t be the last weird story of a stock price completely divorcing from fundamentals before the bubble eventually pops.
— Assistant Professor Tristan Nighswander

As far as long term repercussions, nothing is immediately clear. The Thursday after the GME squeeze, Robinhood, the trading app many WSB traders use, stopped allowing users to buy GME for the day. While they reopened purchases of GME after massive public outcry, the damage had been done. GME dropped to $50 a share: much higher than its humble $4 origins, but well below its peak at $347. GME recovered slightly after Robinhood opened it back up, but, after a slight recovery, it’s price has fallen back to $60, losing a lot of redditors a lot of money. Many WSB users have raised ideas about filing a class action lawsuit against Robinhood, but they don’t hold much water. Robinhood closed purchases of GME not primarily because of a hatred for working class investors, but because it put a massive financial burden on them to make those trades. Early WSB investors on Robinhood largely weren’t buying actual stock, they were mostly buying options contracts. An options contract is a contract with a broker. You pay them a little money now and you get the option at a later date to buy a share of a certain stock (in this case, GME) at a fixed price. If the actual price is significantly higher than the price you agreed to buy at, you saved money by buying the option. If the actual price is lower, then you don’t buy the stock and you lose the money you paid for the contract. When a broker sells an options contract, they usually hedge their bets a little and buy a calculated amount of the traded stock so that, just in case they lose the bet, at least they won a little bit back in their investment. Robinhood was buying a lot of GME stock to hedge their options contracts, and at some point they just couldn’t afford to keep doing that.

The bigger problem with the class action lawsuit is that Robinhood users sign a terms of service clause that broadly prevents them from suing Robinhood in court, and instead they agree to arbitration. Arbitration is basically a court-like proceeding that’s mediated by a third party. It doesn’t mean that Robinhood will win every case that comes their way, but it does mean that plaintiffs have to file individual lawsuits, not class action. This greatly reduces the damages that can be sued for, because the price of filing your own lawsuit is something not everyone can afford. Robinhood’s arbitration clause does, however, have a chance of backfiring against the company. Because each case has to be handled separately, if enough people file suit against Robinhood, their legal costs could be massive, as an arbiter and lawyer have to be hired for every case.

Nighswander weighed in with his own appraisal of the events. There will likely be no regulatory lash back from the U.S. government, and the GME explosion itself probably isn’t going to send that many ripples through the stock market. While the circumstances are odd, the actual mechanics are no different from the market manipulation billionaires use all the time. All is not looking well, however, for the stock market, Nighswander says:

“I do expect to see more events like this in the coming months and years because the entire stock market is currently, in my opinion and the opinion of many professional investors, way overpriced relative to fundamental value. When the stock market is in a bubble and prices exceed fundamental valuations, there are lots of stories like this that occur as investors chase high returns before the house of cards falls in on itself. The late 90s and 2000s were full of wild get rich quick stories like this when we were in the height of the tech bubble, and given the incredibly low return on safe assets like government bonds and the high amount of cash on hand for many individuals who were not financially hurt by the pandemic, there will be more opportunities for extreme returns on dubious investments in the near future. Whether that’s driven by reddit and stonk memes, hedge funds, or billionaires I don’t know, but I’m sure this won’t be the last weird story of a stock price completely divorcing from fundamentals before the bubble eventually pops.”

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Akeel Din
Akeel Din
2 years ago

Tools like Robinhood and economyx.AI level the playing field. So smaller investors feel confident competing with the big boys

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