Getting Started with Cryptocurrency
February 2, 2021
GameStop (GME) will be remembered as the event that started a change on retail investor market behavoir. There is even an initiative to make a movie based on recent events.
News of the GameStop stock’s recent explosion in price has made major headlines across the globe.
Just what happened with GameStop’s stock? And what can we expect to happen next?
Demand Fuels Stock Prices
Stock prices change over time, and so-called long trading involves purchasing a stock that the buyer thinks will increase in value over time, which they can then sell at a profit in the future. A stock is worth what people are willing to pay for it, and a group of amateur investors, organized primarily on the Reddit subforum “WallStreetBets”, decided to collectively purchase GameStop stock to raise its value. The venture was a success, to say the least; GameStop’s value rose by as much as 1,700 percent!, meaning even modest investments paid off significantly. Other companies, including AMC Entertainment (AMC), saw more modest but still substantial gains thanks to this type of online collaboration.
Why GameStop?
GameStop has been struggling for some time. Even though it’s probably the only major video game retailer still in existence in USA, its long-term sustainability as a brick-and-mortar retailer has come into question over the years. Video game publishers are moving to online sales in a big way, a trend that’s only expected to accelerate in the coming years. Furthermore, competition is fierce, as many people see little advantage in going to GameStop instead of just stopping by any other retail vendor. Furthermore, Amazon’s quick delivery throughout much of the United States and the rest of the world, means online orders don’t require much of a wait. Like many retailers, GameStop has struggled due to the coronavirus pandemic. This set the stage not only for a low purchase price with potential upside, but it also made the company a target for short sellers.
What is Short Selling?
To understand what is going on in recent days, one should understand what short selling is. Many people have heard the “buy low, sell high.” For some financial organizations, however, there’s another way to make money: Short selling. So, what is it? Instead of buying stocks expected to increase in value, short sellers instead pick out a stock they believe will lose money over a period of weeks or months. These organizations then “borrow” stocks from an organization that holds them, which they promise to return in a set period of time. They then sell the stock, planning to purchase the stocks again near the end of their loan. While they make some money through transaction fees, the real prize happens if they’re able to buy the stock at a lower rate when it’s time to return it. If a stock’s value drops by 10 percent, for example, they’ll make a roughly 10 percent profit.
Short selling has a further effect: When investors notice that a particular stock is being shorted, they often sell as well, as those who short stocks generally perform excellent analysis and have good reason to believe the stock is going to lose value. This downward pressure places struggling companies in an even more difficult position. Furthermore, media such as CNBC tend to bring aboard analysts whose advice often coincides with what major short sellers want to happen. Whether the practice of short selling is beneficial or not depends on who you ask, but it’s common practice on Wall Street, and there are some arguments that it’s beneficial to the market by adding liquidity. Still, the practice seems to cut at the heart of how most people think Wall Street is supposed to function. People ask me, is it legal? My response: Well, it’s not prohibited.
How GameStop Investors Disrupted Wall Street
Short selling is about buying back a stock in the future. What happens, however, if the stock increases in price by 1,700 percent? Companies are left holding an absurdly high bill, especially with how much money they’re able to borrow to make these purchases. Hedge funds, in particular, were badly hurt; Melvin Capital, for example, sustained a 53% loss in January 2021 and had to be bailed out to the tune of 2.8 billion dollars by other investors.
In normal situations, companies who short a particular stock might see that it’s increasing in value and purchase the stock earlier than planned in order to avoid even higher losses in the future, which leads to a spike in the price known as a short squeeze. With the confusion surrounding GameStop’s rapid increase in value, however, many short sellers were left wondering just what was going on. The stock market is unpredictable, but there are certain parameters investors are used to. What happened with GameStop obliterated typical Wall Street norms, leaving everyone involved scrambling to avoid potentially catastrophic losses.
What Was the Response?
Users of WallStreetBets tend to have a bit of a libertarian ideology, but many on the left, long critical of the inner workings of Wall Street, were also pleased to see hedge funds and other investors seemingly exposed. Most of the outrage at what happened came, unsurprisingly, from people allied with those who lost a significant amount of money, placing them in the uncomfortable position of asking for greater regulation despite having a long-standing position of opposing regulation.
What Happens Next?
It’s difficult to project what the end result of the GameStop situation will be, partially because the situation is ongoing. Perhaps GameStop, now flush with cash, will be able to resuscitate their struggling business. One the other hand, its fundamentals are still in poor shape; how long can the stock maintain its inflated value before investors jump ship? Furthermore, there will be pressure on Congress to act in some way, as Wall Street has considerable influence on both major political parties.
Nevertheless, the populist appeal of seeing elite investors lose while regular people make a significant amount of money will likely temper any potential legislation. Perhaps the most likely laws to change will relate to market manipulation, which is illegal but notoriously difficult to pursue and rarely prosecuted. How can regulations prevent a group of online investors from manipulating the market, and will there be some action to limit the extensive toolkit of manipulative activities established Wall Street firms use on a regular basis? Only time will tell, but undoubtedly lesson should be learned by all parties.
