What a wild couple of weeks!
I’ve never seen trading like the past two weeks. Most people haven’t.
Although there is plenty of information to unpack from the past two weeks, my guess is this story will continue, likely with a book or movie. There are already a few movies in the works. Some people have made a ton of money. Others have lost billions. Before it’s over, there will likely be more fortunes made and riches lost.
Before we get started, nothing in this post is investment, legal, or financial advice. It’s purely my opinion and for entertainment purposes only.
Although what happened recently is not investing, there are plenty of lessons and reminders in it. Even though I worry about people who are taking excessive risks right now, I like the opportunity it provides to open the world of finance for people who normally would not take time to learn about it.
First, let me repeat, people buying GameStop recently were not investing. They were gambling. They were speculating. It was not investing.
If investors want to gamble, they can, but it’s important to recognize the difference between gambling and investing.
Investing won’t make you rich in a month. Investing should be fairly boring. Investing is building good habits, being disciplined, and allowing compounding to work for you.
Gambling is taking risky action in hope of a huge payoff. Gambling is buying a stock that is up over 1,400% in a month. A month! Gambling can make you rich in a month. Heck, it can make you rich in less than a minute with a lotto ticket or putting it all on black in Las Vegas.
What Happened with GameStop? A Brief Background
A user on a Reddit forum, WallStreetBets, posted a picture of a $53,000 investment they made in GameStop in 2019. As with most online forums, not much happened. Some people made comments saying they should sell and life continued.
Fast forward to mid-January of 2021 and the stock started to take off. Along the way, famous names, such as Michael Burry and Elon Musk, have made their way into the conversation, which has likely fueled even more speculation in the stock. The stock went from about $19 a share at the beginning of January to over $300 a share by the end of January. In a month, it gained over 1,400%.
This is a brief background. You can read more about it.
Let’s dive into the financial part.
Breaking Down The Financial Aspects
GameStop is a heavily shorted stock. In short, this means many investors are betting the stock price will go down and if it does, they will profit.
I am going to provide the traditional financial explanation first. If you want to skip ahead to a fictitious example in terms you may better understand, skip to the bottom of this section where you see the Game Boy picture.
What is shorting a stock? You can short a stock by borrowing shares from another investor, selling them, and promising to pay them back in shares in the future. While you borrow the shares, you pay a borrow fee. The borrowing fee varies depending on the stock you are shorting. The fee is higher for harder to borrow stocks. The average borrowing fee for US stocks is under 1%, but GameStop hit 50% for new short bets. That’s incredibly expensive.
For example, you can borrow Stock ABC at $10 a share, sell it at $10, wait for the price to go down to $5 a share, buy it back, and return the shares. In that situation, you sold one share at $10 and bought it back for $5. You made $5 on that trade minus what you paid as a borrow fee.
You can short stocks for speculative purposes, but you can also use it as a way to hedge other portfolio positions. For example, if you own Stock ABC and want to protect part of your investment if it goes down, you could establish a short position. I mention this because many people take issue with shorting stocks, but it can be a risk management tool. Also, it can uncover fraud in companies and make markets more efficient.
Shorting stocks is extremely risky because your loss can be infinite.
In the previous example, if Stock ABC went up to $20 a share, you now have a $10 loss. If it went up to $1,000, you now have a $990 loss. As long as the stock keeps rising, you are on the hook for those losses.
The problem is that as the stock keeps rising, you eventually need to cover your position by buying back the shares. Brokerage firms only allow you to borrow to a certain level before they require you to cover your position.
GameStop is a highly shorted stock. The short interest is over 100%, which means over 100% of their outstanding shares had been sold short. If you are curious how more than 100% of the shares could be sold short, you can read this.
The users on Reddit determined that many hedge funds were shorting GameStop through regulatory filings and decided to stick it to them. They started posting memes and comments about how if they all bought shares or call options, they could artificially drive up the price and create huge losses for the hedge funds.
They create huge losses by creating a short squeeze or gamma squeeze. The users on Reddit crowdsourced demand for GameStop stock and as more people entered the action, more buying bid up the GameStop stock price. As you’ll recall, as prices rise, short sellers face losses.
The hedge funds, who were short GameStop stock, were now facing billions in losses. As prices continued to rise, they had to buy back shares to return the ones they borrowed. Since GameStop is a smaller company with fewer shares outstanding and there was a huge demand for shares as more people bought shares, the hedge funds had a harder time buying shares. Their desire to quickly buy shares only drove up the price further. Said simply, there is way too much demand and not enough supply of shares. This is a short squeeze.
It gets better though. Or, worst, depending on how you are thinking about it.
Although people bought shares outright, many people bought call options. Without getting into the weeds about options trading, a call option is the right to buy a stock at a certain price in the future. A call option is a bet the stock price will go up. Options provide a source of leverage, which means your gains and losses are magnified and it costs less to make the trade than actually purchasing the stock. This is key because you do not need as much money to trade options.
When investors buy call options, they usually are interacting with a market maker whether they know it or not. The market maker often hedges their position by buying or shorting a stock. In the case of a call option, the market maker may buy the underlying stock because when they sell you the call option, they are short the stock. They want to manage their risk exposure and not face an infinite loss.
In the case of GameStop, people were buying call options, particularly deep out-of-the-money options. These have low premiums (or the amount you pay) because the call option is betting the stock will rise to a much, much higher price than where it is trading today. In other words, people did not need as much money to buy these call options, so they could buy a lot of them.
As people bought more call options, this caused market makers to buy the stock, which added even more fuel to the fire for the price to rise. Said simply, people were buying call options, market makers hedged their position as the stock price rose, and as the stock price continued to rise, they had to buy even more shares to hedge their position. This led to a gamma squeeze.
A lot of money was lost in the last week of January. In fact, it’s estimated about $20 billion was lost in January by GameStop short sellers.
What’s fascinating about what happened is how it was a coordinated battle. You had people from across the world deciding to all buy the same stock and dedicated to continue buying it. The more they bought, the more losses the hedge funds suffered. It’s a little bit of a David and Goliath story.
For years, people have felt like Wall Street is always on the winning side of trades. They could trade and get bailed out if something happened. In fact, one of the hedge funds, Melvin Capital, took in around $2.75 billion from two other hedge funds, Citadel and Point72 Asset Management, recently after they lost about 53% in January.
For the first time, people are cheering on the “small investor” profiting over Wall Street. As I said earlier, this was a coordinated attack where people stuck it to the hedge funds and anyone else short GameStop stock. Although “small investors” were mostly in the news, there are plenty of professional investors and hedge funds that profited from the mania recently. We’ve seen the price come back down with it dropping about 80% in the past five days. After the mania from the prior week, there were plenty of winners and losers this week. People who bought at the top last week are likely hurting this week.
I promised earlier a simpler explanation of what happened recently. There are more nuances to what happened, but this is a simplified version. Let’s begin. I grew up in the 90s when Game Boys were all the rage.
Who didn’t love Super Mario, Pokemon, or Zelda? Imagine there was a really wealthy person in your town most people didn’t like. Let’s call him Adam. Adam thinks Game Boys are toys of the past, and new, better toys will come out soon. He is positive Game Boys will be selling for less in a few months.
Adam decides to borrow all the Game Boys in your town when each one is worth $5, gives you a little money for the privilege of borrowing it, and tells you he will return it in a month. He sells all 100 of them for $5. He now has $500 in his pocket. He is feeling good because he is confident in a month, he can buy them back at $1 or even less. When he does that, it will cost him $100 and he will make $400 on the transaction.
Unfortunately for Adam, Lucy hates him and discovers what he is doing. Lucy decides to talk with her friends in the neighborhood, and they agree to buy as many Game Boys as possible. They start buying the Game Boys. Some even offer to pay 50 cents for the right to buy Game Boys for $10 six months from now, even though the current price is $5. Over the course of the month, Lucy and her friends buy nearly the entire supply of Game Boys.
A month from now, Adam starts looking to buy Game Boys. He is shocked. There are only a handful of Game Boys available for sale and they cost $8. He does not want to buy them at $8 because he is confident they will be worth less in the future and does not want to pay $800 because he would lose $300 on the transaction. He decides to give you more money to continue borrowing the Game Boys he already borrowed and sold.
Lucy continues her crusade to destroy Adam. She starts telling other neighborhoods about Adam, and they start to buy the limited supply of Game Boys. The price goes up to $15. Adam is getting really nervous but still does not buy them. “There is no way a Game Boy is worth $15 when it was $5 about a month ago”, he says to himself.
Fascinated by how quickly Game Boy prices are rising, more and more people start buying from around the world. Some are even offering $1 for the right to buy Game Boys at $75 a year from now. It seems crazy, but that results in even more people buying the Game Boys at higher prices. When Game Boys reach $50 a share, Adam decides he had enough. Adam buys back 100 Game Boys for $5,000. Remember how Adam pocketed $500 when he sold the borrowed Game Boys? Adam just lost $4,500.
However, Adam has other wealthy friends that know Game Boys are not worth $50. They decide to borrow 100 Game Boys and sell them for $50 apiece. They pocket $5,000, but Lucy’s message of buying more and more Game Boys continues to snowball. As more people want them and join in on the frenzy, the price of a Game Boy skyrockets to $300. Adam’s friends who borrowed them at $50 now have to buy them back for $30,000. They lose $25,000.
Along the way, both sides know what is happening. Adam’s friends know the Game Boy is not worth $300, but it costs them too much money to continue borrowing the Game Boys, so they are forced to buy them at whatever price they can find them. Lucy and her world domination herd also know a Game Boy is not worth $300, but they know as long as they keep buying, the price will continue going up and create huge losses for Adam and his wealthy friends.
It’s like a game of chicken. There is plenty of interest from both sides, but eventually, one side will lose interest and the price will come back to a reasonable level. Until then, many people are going to make a ton of money while another side loses a ton of money. Then, it will reverse. We saw that this past week as GameStop is worth about $18 billion less than last week. It may fall further. We may see people try to push the price up again. Check out the chart below.
As John Maynard Keynes said, “the market can remain irrational longer than you can remain solvent.”
What Happened with Robinhood?
Now that you know what happened, let’s look at another controversy with Robinhood, one of the broker-dealers in the news recently.
Robinhood has faced a backlash from regulators and other industry experts for gamifying trading. One tragic example is the 20-year-old who committed suicide in 2020.
Although they made investing more accessible, there are many criticisms of Robinhood, particularly of how they make money. Since they were one of the first brokerage firms to focus on commission-free trading, they needed to make money somehow. They do that by selling their customers’ trades to other firms.
For example, if a customer bought a share of Starbucks, they might route that order to a company like Citadel Securities, which would pay Robinhood for routing the order to them. Citadel would then complete the trade and make money off the trade. At best, it’s a conflict of interest.
It’s important though because the CEO of Robinhood had a terrible interview explaining what happened. His words left people imagining nefarious actions – that Robinhood catered to the whim of Citadel and other hedge funds who paid them. Robinhood prevented buying in GameStop and other investments in January claiming it was to protect customers. He went around the question of whether they had liquidity issues and denied having them. If it was not liquidity issues, people speculated hedge funds were telling Robinhood to halt the buying of GameStop because of their business relationships. This would help the hedge funds that had short positions. It seemed like Robinhood was looking out for Wall Street – not their customers.
Later, Robinhood admitted they had liquidity issues, even on their own website. Why they did not admit this in the first place, I do not understand. It would have led to bigger questions about their financial stability, but it would have stopped the rumors about caving to the demands of hedge funds.
What is concerning is that a company that always touted how they were for main street investors and encouraged trading were not equipped to handle the trading they encouraged.
When you trade, you probably don’t think about what happens behind the scene, but when you buy a stock, the trade does not actually settle for two days. In the background, brokerage companies, like Robinhood, need to deposit money with clearinghouses. The amount varies depending on what is happening in markets and the types of trades happening. When GameStop shot up in price, their deposit requirements increased ten-fold. They couldn’t meet those requirements, which is why they restricted buying in certain stocks. Customers were not happy about not being able to buy certain stocks, such as GameStop.
It’s not a good thing when the company that encourages you to trade can’t actually support your trading because they were not financially prepared. In fact, they had to raise $3.4 billion.
Other brokerage firms, such as TD Ameritrade and Schwab, did not restrict buying. They did restrict certain types of transactions and changed margin requirements.
At this point, it seems like Robinhood did a poor job explaining what was happening and was not prepared financially.
What Happens Next?
My guess is there will be an investigation of some sort – both into Robinhood and the legality of what is happening on Reddit. We already see politicians wanting to hold hearings.
People will continue gambling. Some will get very rich. Others will likely lose more than they can afford. People will be taught the difference between speculating and investing.
Like a party, you can have a great time while everyone is participating, but if you arrive late or stay too late after everyone leaves, you are the one left to clean up the mess.
Was GameStop really worth over $400 a share at one point? Should the entire company have been bid up to be worth about $33 billion? Probably not, but that is where it was at one point. We’ll see who ends up being late to the party – and there will be plenty of people who are late. You saw it this week. We’ll likely see more of it.
What Lessons Should You Takeaway?
The story hasn’t ended yet, but there are clear takeaways.
The first is to know the limits of smaller companies. Innovation is great, but it also means there can be learning and hiccups along the way. Robinhood is a relatively new company in the brokerage world and their liquidity issues last week were on full display. They simply did not have enough money to place with clearinghouses to meet the buying demand of their customers. The larger, more established brokerage firms did not restrict buying as Robinhood did. If you put your life savings somewhere, consider a company that has demonstrated its ability to operate smoothly through many different market events.
The second is having an investment plan you follow. Write it down. Seriously, write down your investment philosophy, why you would make changes, and how you select your investments. If it isn’t written down, you may be tempted to jump in on the mania.
If you want to speculate or gamble with a small amount of money, I think that’s fine if you can afford it. I allow myself one or two “stupid trades” per year. I use quotes because I know they are dumb and I will likely lose most, if not all my money, and I am okay with it. Investing should not be exciting, and I know if I get to make one or two exciting trades per year with an amount of money I don’t mind losing, I can stay focused with my other investments.
The third and final takeaway is knowing the difference between gambling and investing, as well as the role luck plays in individual stock picking. Plenty of people made a ton of money over the past two weeks. I truly mean a ton of money. More money than you may make in your entire life and your children’s lives.
It’s natural to feel like you missed out on something. When you see people make thousands, hundreds of thousands, and even millions of dollars in a month, there will be a feeling of regret. You’ll ask yourself, “Why didn’t I buy shares?” Remember, they got lucky. None of this is a foregone conclusion. Nobody could have predicted it. Most people don’t build wealth this way.
Investing and compounding normally takes a lifetime – at the very least, it takes more than a month!