David vs Goliath

We know that institutional investors, hedge fund managers, mutual fund managers are the ‘smart money’. Together, these professionals and sophisticated investors have more capital, resources, expertise and experience (and influence) in investing.

We, retail investors, are ‘dumb money’ — gullible, slow and irrational investors who will likely lose in the investing game.

However, something happened that caught the attention of the media recently.

A Surging Stock

By surging stock, I don’t mean Tesla. It was Game Stop (GME).

Game Stop is a chain of retail stores that sell video games, gaming merchandise and electronics. 

Given the trend of consumers going digital, lockdown due to COVID19, it is not surprising that Game Stop did not do well recently. 

At the beginning of the year, the share price was around ~$18. Suddenly, on Jan 27, 2021, the price shot up to a high of ~ $347. 

Share price of GameStop GME

What happened?

Short Selling

Short selling is a way of profiting from falling share prices. This concept involves borrowing the shares, selling the shares, and buying back the shares at a lower cost to return to the lender.

For example, if I consider that Game Stop is currently overvalued at $18, I could short sell the share at $18. When the share price eventually drops to $10, I buy back the shares to return to the lender and pocket an $8 profit (ignoring interests and other trading fees).

However, short selling is risky because you borrow shares from a lender which you have to put some collateral. If the share price goes up, the lender will demand more collateral or lose patience and demand back the borrowed shares. When that happens, the short seller may need to buy back the shares at a higher price, at a loss.

Short Squeeze

In economics, when demand increases and supply decreases, the result is an increase in prices.

So, if suddenly the price of a particular share explodes, all the short sellers of that share will scramble to buy back the share to cover their losses.  

In the case of GameStop, hedge funds that had a large short position were forced to buy back large quantities of that stock. Suddenly all the short sellers have to buy back the stock, but not enough people were selling. It caused the share price to go up even more. 

This phenomenon is referred to as a short squeeze.

A Coordinated Attack Via Social Media

It started when a group of retail investors and day traders wanted to target successful hedge funds. 

They knew that Melvin Capital, the targeted hedge fund, had a substantial short position in Game Stop.

Hence, they coordinated on Reddit and artificially inflated Game Stop’s price and caused a short squeeze. It resulted in hedge funds closing its position and losing a substantial amount of money.

Efficient Markets? Irrational Behavior? Neither.

The efficient market hypothesis states that the price reflects all information available. 

In this case, the increase in GameStop’s price is not a result of any new information.

The stock price is also not driven up by irrational investor behaviours such as greed or fear.

Instead, the price increase is a coordinated attack by very rational investors. It shows how the market can be manipulated.

We used to think that large institutions or funds have the power to manipulate markets. But now, with the power of social media and zero-cost trading, retail investors could also take on giant hedge funds.

Conclusion

Some may think it is illegal (and it may very well be). But others may feel that it is comeuppance for these large hedge funds.

Beneath the surface of this, perhaps lies a more significant issue of inequality. 

Inequality has always been an issue. The gap between the wealthy and poor has been widening even more after the recent pandemic.

While small companies and regular workers suffer, most of the wealthy get more affluent with the stock market inflating due to various monetary and fiscal policies.

The Robin Hood story, robbing the rich to feed the poor, appeals to many of us. Maybe we felt some sense of injustice about the rich getting rich at the expense of making more people poorer. 

Judging from the funny memes about GME in the wallstreetbets subreddit, they seem serious about holding their position and keeping the share price up.

Whatever the motive of the traders at r/wallstreetbest may be, it appears that they resent wall street and want to take down Goliath or, the very least, send a message.

Don’t bully the small fries.

Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

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