By now, we have all heard about the war between the Redditors of r/wallstreetbets and the big hedge funds — and whether you are investing in the market or not, you’ve most likely heard about the phenomenon of Gamestop. Arguably, it has become a household name due to ridiculous circumstances.
For those who don’t know the story: Melvin Capital, a hedge fund, believed they could make a profit by short selling Gamestop shares. Short selling, or shorting, means an investor, (in this case Melvin Capital) borrowed a number of securities (stock or assets) from a company — Gamestop — with the intention to sell them on the market.1 The hedge fund sold the stock, with the expectation that the price will drop. If it had dropped, the stock would be bought back cheaply, and returned to Gamestop. The difference between the selling and buying price then becomes profit to the hedge fund. This privately organised financial strategy isn’t a new concept, however, as Redditors of r/wallstreetbets caught wind of what the hedge fund was planning to do and drove up the stock price by buying the shares, with no intention of making a profit — committing to holding the securities they bought to ensure Gamestop stayed afloat.
All of this was possible because of the media attention Gamestop and r/wallstreetbets received. Because share prices are determined by demand, much like how the price of certain commodities soared during the panic-buying stage of COVID-19 last year, Gamestop shares (GME) also appreciated, but for different reasons. Over the course of January, GME slowly saw an increase in value, until people noticed what the Redditors were doing and began to jump on the bandwagon. There was a rapid escalation of security purchases, with individuals joining the cause for reasons such as:
".. trying to ‘get rich quick’ or just sticking their middle finger to larger institutions."
Whatever their reasons, the bandwagoning resulted in what is known as a short squeeze. On the 26th January, GME closed at $147.98 USD, a dramatic increase from the previous day’s close, of $76.69 USD. A day later, GME closed at an incredible $347.51 USD, and currently has a 52-week high of $483 USD. It’s a large stretch to say anyone could have anticipated this. The Gamestop situation has made it clear that successful short selling requires money, expertise, and a capacity to take risks.
What we see is the result of spite, opportunity, and desperation to save a well-loved company. But let’s talk about the opportunists. In my opinion, they are the reason the short squeeze occurred. In economics, the greater fool theory states that the price of an object is determined by demand, and people can make a profit from this by selling an asset to someone who is willing to pay a higher price. Put simply, you are a fool selling something to a fool greater than yourself. For the opportunists, GME was a short-lived gold mine, and the problem with investors suddenly buying into it was that it created a temporary market price bubble, where the price of a good rises far above the item’s real value.2 It’s unsustainable and has resulted in a market correction, which we now see in the GME trend.
Hedge funds are, understandably, seen as the bad guys, who’d do anything to make a profit. This reputation is not unwarranted; hedge funds are exclusive to, and run by, the already wealthy. Rich people are able to get even richer by investing in high risk stocks. The nature of the industry also attracts ambitious people driven by money. We see this trope in films like The Wolf of Wall Street — good people are corrupted by the ruthless work culture and become greedy.
"..Martin Scorsese paints a grave reflection on the sordid nature of society, by emphasising all that is wrong with our work ethos."
Though, it’s important to take such media portrayals with a grain of salt. Short sellers have a legitimate and positive role in the efficiency of markets as they can help provide the opportunity for price discovery in the stock market. Essentially, it involves finding where supply and demand meet, determining a suitable price of an asset by acknowledging ‘investor risk attitudes, and the overall economic and geopolitical environment’.3 It’s when short sellers seek to manipulate pricing for their benefit, and potentially break securities laws, so they become a detriment to the orderly conduct of financial markets.
The reality is businesses fail, and what the hedge funds are doing is merely making risky bets on companies they believe will go under. A bunch of Redditors pulled off a glorious stick-it-to-the-man moment and it’s difficult not to be amused by it. Among all the excitement and speculation, I cannot picture what this means for the future of hedge funds and investors — though, it seems like it was a win for the little guy this round.