How GameStop heroes had their asses handed to them!

The Reddit / Wall Street Bets price manipulation of GameStop has been reported in the mainstream media as a great victory for amateur traders over the evil hedge fund guys; but history will report the event differently. An objective review of the so-called short squeeze that played out on US markets in January and February 2021 will reveal how gullible individual investors were cajoled into purchasing worthless paper to enrich a handful of their peers. It will also be remembered as a time when gamblers and speculators outnumbered investors in global markets by thousands to one.

GameStop (NYSE: GME) is one of many New York-listed shares that had been in gradual decline heading into 2020, trading as low as US$2.57 and ending the year at US$18.84 per share. Stock market analysts describe the firm as a struggling video games retailer that was more likely to file for bankruptcy than surge to a multi-billion dollar market valuation. US-based hedge fund managers who had spotted the firm’s shaky fundamentals were circling its carcass like a pack of hyenas last year. They decided to take advantage of the situation by short-selling the share, expanding their short positions into the rising price. 

The basics of short selling

Short selling is a legal trading strategy that allows investors to make money when the price of a share falls. A short seller is required to borrow the number of shares he or she wishes to short when taking the position. An investor looking to short 1000 Tiger Brands shares can borrow these shares from a brokerage, fund manager or pension fund and then sell them on the open market. The borrowing requirement prevents short sellers from selling more shares into the market than are in issue at any given time. At some time in the future, the short seller has to buy back the shares in order to return them to the borrower. 

It is worth exploring the difference between traditional equity funds and hedge funds. A traditional equity fund generates returns for its investors by carefully selecting and investing in companies that it expects to increase in price. The fund manager of a traditional equity fund will deploy accumulated investor capital to buy shares outright and will only generate a capital return when it sells these shares at a higher price. A hedge fund, meanwhile, can use complex trading strategies such as leverage and short selling to improve its overall return performance. A long/short equity hedge fund manager can thus make money from both falling and rising share prices. 

Short selling is risky because the losses are theoretically uncapped. If you buy a share for ZAR100 your maximum potential loss, assuming the share goes to zero, is ZAR100. But if you short a share at ZAR100, your loss grows the higher the price goes. If the share goes to ZAR300 you will lose R200 plus the cost of borrowing the share to begin with. This type of investment strategy is best left to the pros; but even the pros get it wrong. Short sellers of Tesla Inc (NASDAQ: TSLA) reportedly lost US$38 billion in 2020 as the share continued to reach new highs, while short sellers of GameStop lost billions too, as we describe below. 

The mechanics of a short squeeze

Hedge funds were shorting millions of GameStop shares during 2020, adding to their short positions even as the share price climbed. As we entered 2021 a group of amateur investors on a Reddit-subgroup called Wall Street Bets became aware of the size of the short book on GameStop and a handful of other shares. They used the Reddit forum and other social media platforms to engineer a short squeeze. In plain language, they encouraged as many individual day-traders and individual investors as possible to buy GameStop shares and chase the price higher. The short squeeze occurs when the price goes so high that hedge funds are forced to close their short positions, creating more demand for the share, and chasing the price higher. 

Most market commentators have positioned this successful short squeeze as a David versus Goliath battle, with amateur day-traders and investors beating the institutional hedge funds at their own game. The combination of the Wall Street Bets’ buying frenzy and ensuing short squeeze sent GameStop to an intraday high of US450,00 on 27 January 2021. Thousands made money; but many more will have suffered massive losses. “GameStop is not an asset and it was being chased by amateurs, they are not investors but gamblers … and they are going to learn the hard way as all of us do,” said author and property investors, Robert Kiyosaki, in an interview on KITKO News, 4 February 2021. 

Lose big and go home…

Those who got into the share early, at prices around US$20 per share, made a killing. Unfortunately, anyone caught long the share for more than US$100 is on track to lose more than half of their speculative investment. Once the short positions were unwound and the stock was left to find an appropriate price level it quickly retraced to US$50. As Kiyosaki observes: Although the short squeeze had caught some hedge fund managers “sound asleep” there will be consequences for individual investors, most of whom will “get their asses handed to them”. 

We were surprised that none of the debates following the GameStop debacle raised the issue of front running or pump-and-dump strategies. Investopedia.com describes front running as “trading in a stock or any other financial asset by a broker who has inside knowledge of a future transaction that is about to affect its price substantially; a broker may also front run based on insider knowledge that his or her firm is about to issue a buy or sell recommendation to clients that will almost certainly affect the price of an asset”. Pump-and-dump, meanwhile, is a strategy employed by many early crypto coin speculators, who would first take a position in their preferred coin and then hype the coin’s prospects to thousands of their accountholders or followers, chasing prices up. 

On the irrationality of markets and solvency

The persons behind the pump-and-dump scheme would time their exit from the trade to coincide with the ensuing buying frenzy and then wait for the prices to fall back before repeating the process. The questions we should be asking include: Did a handful of well-connected Reddit users have pre-knowledge of the coordinated promotion of GameStop that took place via Wall Street Bets? And how close was the GameStop scenario to a pump-and-dump strategy? 

We leave close today’s op-ed with two parting thoughts. The first is that share trading, whether you go long or short, is a zero sum game. Every dollar taken out by a winning trader is taken from the pocket of another investor on the losing side of that trade. The second derives from a quote by economist John Maynard Keynes, who wrote: “Markets can stay irrational longer than you can stay solvent”. What a perfect description for the craziness playing out on global financial markets in Q1 2021.