GameStop to the Moon

On Wednesday, January 28 the internet exploded into an open revolution against Wall Street. Hordes of amateur investors using retail investment services such as Robinhood and Webull poured money into the stocks of companies that had been left for dead by professional traders. Hedge funds had been investing heavily in shorts on companies like GameStop, AMC, Blackberry, and Nokia, using fundamental financial information to bet that their stock prices would fall in the months ahead due to the pandemic and the relative obsolescence of these companies.  Members of the Reddit community r/WallStreetbets and tens of thousands of other small investors decided to stick it to the hedge funds by buying stock in these companies, creating a national movement that led the stock prices of these companies to skyrocket. This phenomenon evolved into one of the largest internet events to date, breaking out of Reddit and gaining followers across all social media platforms. This further fueled the buying conflagration and caused stock prices to soar even higher. 

To understand how and why this all happened you must first understand hedge funds and the practice of short-selling stock. Hedge funds are investment portfolios managed by professionals that aim to invest in a wide range of securities and equities to reap the highest possible returns despite market volatility. What really makes a hedge fund different from other forms of investment is that they are only available to “accredited investors.'' This restriction means that only very wealthy investors can participate. For example, you may only be able to join a hedge fund if you make upwards of $200,000 per year, have a net worth of at least $1 million, or serve as an executive at the hedge fund. In this wave of investment in struggling companies, hedge funds were targeted for an excess of short-selling stock. Short selling allows investors to make a bet that a company's stock price will decrease and profit if it does. To short a stock, hedge funds borrow stock from a broker and then immediately sell it back into the market. No matter where the stock price goes, hedge funds must buy back their shares and return them to the original broker after a predetermined amount of time. If the funds made a good investment the prices will have fallen when they need to return the stock so they will profit off of the difference. Large hedge funds such as Citron Research and Melvin Capital have invested heavily in short positions on companies like GameStop in recent years. They adopted this strategy for logical reasons: GameStop and the mall retail business, in general, are becoming increasingly obsolete, and consequently GameStop has been making less money. For the most part, hedge funds were right: GameStop stock has fallen steadily, from about $30 in 2017 to $4 in December of 2020. Unfortunately for hedge fund managers, they couldn’t predict the power of a social media frenzy that came barreling towards them like an avalanche. 

R/wallstreetbets has grown in popularity over the past year as many young, mostly male, individuals have used the stock market as a way to entertain themselves and make money during the pandemic. Aided by retail brokerage services like Robinhood, E*trade, and Webull, this army of new-age day traders has treated the stock market like a casino. WallStreetBets has allowed them to collaborate and discuss their strategies, winnings, and woes. At some point in the past months, members of this community learned of hedge funds who were shorting stocks like GameStop, recognized the vulnerability of those funds, and decided to exploit their weakness like David firing his sling into Goliath’s forehead. To these middle-class investors, hedge funds represent the elite and perpetuate the cycle of wealth inequality in America. They decided to buy GameStop and other declining companies that hedge funds targeted to drive up the value of those stocks. Not only did they succeed, but they launched stock prices directly where their rallying cry suggested, “to the moon.” GameStop stock, which had already been pushed up from its $4 low point to about $40 by January 21, skyrocketed to nearly $400 in 5 days, with almost all of the growth happening on the 26th alone. Unlike typical investors, most of these stockholders did not aim to make a profit by selling the stock at its peak. Rather, the online forums and their memes encouraged all members to “hold the line” and not sell to inflict maximum damage on the hedge funds. To a large extent, their movement was successful. At the end of January, the hedge funds that had been shorting stocks lost over five billion dollars. Citron Research closed out all of their GameStop short positions when the stock hit $90 at an extreme loss. Melvin Capital required a cash injection of about 3 billion dollars from associated hedge funds to bail them out of their GameStop losses. The army of traders was able to inflict losses this severe due to the nature of short positions. When investors buy stocks, they can lose only as much money as they put in. But when shorting, an investor does not have an upper bound for losses, as they must repurchase the stock to return to the broker at the value, it’s at, even if that value has increased exponentially. Forcing these kinds of losses, as the individual investors pitted against hedge funds have done, is known as a short squeeze.  

The internet frenzy appeared to reach a fever pitch on Thursday, January 28th, when most of the popular retail brokerage services blocked the buying of trending stocks but still allowed holders to sell. To many observers, this development seemed like the Wall Street elite manipulating the market for themselves once again, to protect hedge funds that were hemorrhaging value. Politicians echoed this sentiment with Ted Cruz, Alexandria Ocasio-Cortez, and Donald Trump actually agreeing on Twitter in an extremely rare occurrence. Webull, one of the main services for smaller investors, claimed that the reason it halted trading was that it was told by its clearing agency, Apex Clearing Corporation, that trades for trending stocks like GameStop could no longer be settled. Reportedly, the Depository Trust & Clearing Corporation (DTCC) told Apex to offer more collateral to help settle all the trades.  Clearing agencies streamline the trade process between brokerages and the market. The trading process takes about 2 days to settle, and in that time, the clearing agency puts up collateral on behalf of the brokerage to facilitate the trade. The DTCC told Apex on Thursday that the collateral requirements for GameStop trades had been raised to almost 100%. Robinhood was told by its clearing agency to provide three billion dollars to secure its trades. The clearing agencies began to require such an increase in collateral because they were concerned that the high volatility in the markets would lead them to incur major losses.

As we’ve seen in the trading week starting on February 1 the stock prices have started to drop as the trend dies. This will hurt individuals who decided to jump into the trend when stock prices were in the stratosphere, as the prices will never be that high again. However, this occurrence has highlighted the changing nature of the stock market in the age of app-based services and an influx of young investors. Now, people understand the power they can wield by organizing over the internet and taking action, especially if they can grow their cause widely. Hedge funds will no longer share as much information about their short positions, informed by this debacle. For example, Citron Research has already announced it will stop publishing reports on its short positions. This policy also means hedge funds will not be able to publicly criticize companies they are shorting, a technique they’ve employed in the past to bring stock prices even lower. Finally, the role that retail brokerage services like Robinhood and Webull play in the financial system will fall under heavy scrutiny, and these companies will face lawsuits and SEC investigations for the halting or limiting of trading. The past few days haven’t changed the core of Wall Street, but they have certainly shaken its foundation.