Published on March 02, 2021

The GameStop Short Squeeze:
Events and Terminology of Short Selling Explained

For many new investors, long-held strategies such as evaluating company fundamentals have gone out the window in favor of momentum. War has broken out between financial professionals losing billions and the individual investors jeering at them on social media. Meanwhile, the frenzy of activity is stirring regulatory and legal concerns, as well as the attention of the Biden administration. The White House press secretary said that its economic team, including Treasury Secretary Janet Yellen, is monitoring the situation.

In January 2021, a group of largely newbie investors gathered on platforms such as Reddit, Discord, Facebook, and Twitter. They encouraged each other to pile into stocks, while often bragging about their gains, and, at times, intentionally banded together to intensify losses among professional traders, who protested that social-media hordes are conspiring to move stock prices.

GameStop, AMC and BlackBerry have received hundreds of thousands of mentions across social media since early January and have vaulted into the ranks of the most traded stocks in the U.S. market.

Sign up to see which institutional hedge funds on our platform navigated the events that unfolded during the GameStop short squeeze this past January.

What’s Happening to GameStop’s Business?

Despite the recent interest in GameStop, the brick-and-mortar video game retailer has been reportedly losing money for years, shuttering stores, and has seen its stock price decline for six consecutive years (prior to 2020). One of the biggest reasons for GameStop’s struggles had to do with its inability to adapt to the evolution of the video game industry. Specifically, their customer base is no longer buying video games or gaming hardware in physical stores like GameStop, instead opting for more online purchases and digital streaming. As a result, many commentators have called it the new Blockbuster of the gaming world.

GameStop was one of the most shorted of all publicly traded companies. Other companies on the list include AMC Theatres, Bed Bath & Beyond, and even the mostly defunct Blockbuster.

“Can’t Stop Won’t Stop GameStop.” - What Fueled the Interest in GameStop among Retail Investors?

The initial interest in GameStop had some merit. Certain Redditors had been bullish on the company since mid-2019, upon a major selloff that left the stock trading in the low single digits after disappointing earnings. Seeing the depressed stock and bearish view from hedge funds and institutional investors, the Redditors became contrarian to this view and encouraged other investors to buy the stock. The rally in GameStop was initially triggered on Jan. 11 when news broke that activist investor and Chewy Co-Founder and former CEO Ryan Cohen was joining GameStop’s board. The stock jumped in response to the announcement based on hopes that Cohen would drive a change in strategy. This news, as well as outrage upon discovering that the stock was the most shorted publicly traded company, quickly re-energized the now-larger Reddit crowd. Retail investors who followed Reddit used online brokerage sites (example: Robinhood) to facilitate their bullish trades on GameStop through not only buying the stock out right but also using bullish strategies in the options market.

In January 2021, the stock became the darling of day traders who put the squeeze on Wall Street’s big players, including hedge funds. The stock was up 1,745% for 2021 through Jan. 27.

What Is a Hedge Fund?

A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction and risk management techniques in an attempt to improve performance.

As an investment strategy, short selling is widely deployed by hedge funds and other institutional investors, to varying ends.

Source: Wikipedia.

How does Short Selling work?

In simple terms, short selling involves counting on a stock price dropping. Short selling generally involves selling borrowed shares of a stock with the belief that the price will drop, at which point you’d buy shares at a lower price to repay what you borrowed.

With the strategy, the risk on the upside is unlimited. Short selling is a highly speculative strategy that comes with plenty of risks; since there’s theoretically no limit to how high a stock’s price can climb, then there’s also no cap on the losses a short seller could sustain on a bad bet. But it also serves a purpose beyond simply betting on a stock’s losses; many investors use it as a hedging tactic, to offset the downside risks of their more optimistic, “long” positions in the same security or sector.

As of Jan 29, 2021, short selling hedge funds have suffered a mark-to-market loss of $19.75 billion year to date in GameStop, including a nearly $8 billion loss on Jan 29 as the stock kept ripping higher, according to data from S3 Partners, a provider of financial data.

In a recent article on CNBC, amid the massive squeezes, hedge fund Melvin Capital closed out its short position in GameStop after taking a huge loss. Short seller Andrew Left of Citron Research said he had covered the majority of his short position in GameStop at a loss.

GameStop's Wild Week - The stock took off on a trading frenzy fueled by a Reddit message board

Source: FactSet. Data as of market close on Jan. 29.

Why did the Short Sellers Incur These Losses and What is a Short Squeeze?

Retail investors, led by those in the WallStreetBets Reddit chat room, started piling into GameStop, AMC Entertainment and other stocks that hedge funds were counting on going lower. All the buying pushed up the prices, meaning the funds’ bets were wrong and they’ve lost billions of dollars.

The general process: You borrow shares from your brokerage and sell them at the current market price (which, again, you think will fall). Ideally, your view is correct, and when the price has dropped, you buy shares at that lower cost to pay back the ones you borrowed. A simplified illustration: You short a $7 stock. It slides in price, and you buy it at $2. Your profit is $5.

However, if the price goes up, at some point you still would need to finish the transaction — that is, you’d have to buy that stock to repay the brokerage. So, if that $7 stock starts rising, and you buy it at $10 to cover your short position, you’ve lost $3.

When a stock is heavily shorted, and investors are buying shares — which pushes the price up — short sellers start buying to cover their position and minimize losses as the price keeps rising. This can create a “short squeeze”: Short sellers keep having to buy the stock, pushing the price up even higher and higher. This is what happened with the shorted stocks targeted by the Reddit investing crowd.

Generally speaking, you can only engage in short selling using a margin account. This essentially is a loan from your brokerage, which will charge you interest and require you to maintain a certain level of funds in that account. When the value drops below that threshold, your brokerage will require you to replenish the account. Your brokerage also may ask you to cover your short position when the price has gone up.

Sign up to see which institutional hedge funds on our platform navigated the events that unfolded during the GameStop short squeeze this past January.

How did Call Options Supercharge the Short Squeeze?

Many avid Reddit posters hyping up GameStop started buying call options, a type of derivative contracts that give the holder the right to buy the underlying security at a stated price within a specific timeframe. The call options contract values can surge by even larger magnitudes when the underlying stock is rallying by 100% in a single day. Options trading has become accessible and easy to millennial investors, thanks to those new and commission-free apps such as Robinhood.

“This is all a part of the democratization of the market,” said Quincy Krosby, Chief Market Strategist at Prudential Financial. “Normally when we are talking about levering up and options, it typically is associated with investors, professional managers, and hedge funds.”

When retail investors look for cheap upside calls, it leaves the sell-side or the market makers who are the middlemen in the transaction short a lot of upside calls, or short gamma. As the stock rises towards those strikes, the market makers need to buy increasingly more stock to hedge their short calls. This effectively accelerated the rally further in GameStop and other heavily shorted names.

“Retail order flow in the options is essentially supercharging the short squeeze, like the tail wagging the dog,” CC Lagator of Options AI said. “That gamma effect adds buyer after buyer in the stock, with no one able to short the stock because it is hard to borrow. The effect is a massive short squeeze.”

The Saga Continues...

GameStop's Wild 2021

Jan 3$0$50$100$150$200$250$300$350Jan 10Jan 17Jan 24Jan 31Feb 7Feb 14Feb 28

Source: CNBC. Feb, 2021

On February 17, Keith Gill, who goes by the name RoaringKitty on Twitter and YouTube, was hit with a securities-fraud lawsuit over his alleged role in the rise of GameStop stock, according to a court filing first seen by Bloomberg. Gill gained a cult-like following as he documented his "YOLO" trade in GameStop on Reddit's WallStreetBets forum for more than a year.

He invested $53,000 into GameStop stock and call options in June of 2019, and the value of those securities ultimately peaked at about $48 million during GameStop's epic short squeeze.

The lawsuit alleged that Gill misrepresented himself as an amateur investor when in reality he was a licensed securities professional. The suit also alleged that Gill profited from GameStop's rise by artificially inflating the price of the stock.

"Gill's deceitful and manipulative conduct not only violated numerous industry regulations and rules, but also various securities laws by undermining the integrity of the market for GameStop shares," the lawsuit said, according to Bloomberg.

GameStop and the Reddit-fueled frenzy around it have been celebrated as a triumph for small investors. But lots of them are in the red. Salvador Vergara was so enthusiastic about GameStop in late January that he took out a $20,000 personal loan and used it to purchase shares. Then the buzzy stock plunged nearly 80%. GameStop’s volatile ride is hitting the portfolios of individual investors like Mr. Vergara who purchased the stock in a social-media-fueled frenzy. These casual traders say GameStop was their “YOLO,” or “you only live once,” trade. They bought around its late January peak, betting it would continue its astronomical climb. While some cashed out before it crashed, others who hung onto their shares are in the red.

“Game Stopped” Hearing – Highlights

The House Financial Services Committee on February 18 called before it the major players in the rapid rise and collapse of GameStop’s stock as it shined a spotlight on some troubling aspects of equities-market structure in the U.S.

The committee questioned Robinhood Chief Executive Vlad Tenev, Citadel Securities founder Ken Griffin, individual investor Keith Gill — aka ‘Roaring Kitty,’ Reddit CEO Steve Huffman and Melvin Capital CEO Gabe Plotkin.

Government Breaking Up Big Tech Companies

Robinhood CEO Vlad Tenev was in the hot seat for much of the hearing, as House Democrats and Republicans alike excoriated his company. Lawmakers’ ire was not only trained on Robinhood’s decision to halt buy orders of GameStop and other stocks, but other controversies the company’s been involved in. Tenev acknowledged his company’s wrongdoing, apologized for Robinhood’s role in the GameStop crisis, and admitted that Robinhood did not have sufficient cash to post collateral with the DTCC. "I’m not going to say that Robinhood did everything perfect and that we haven’t made mistakes in the past,” he told lawmakers. “But what I commit to is making sure that we improve from this, we learn from it, and we don’t make the same mistakes in the future.”

The way Robinhood makes money – payment for order flow (PFOF), whereby market makers like Citadel Securities pay Robinhood to route users’ trades to their desks – was a recurring theme of debate. And several lawmakers expressed concern that PFOF and big market makers like Citadel pose a threat to the financial system.

“Citadel is one of the winners,” bemoaned Jim Himes, a Democratic congressman who also happens to be a former Goldman Sachs vice president. “They're the casino in this story, and the casino tends to win over time. Robinhood makes a lot of money from the casino.”

Ken Griffin, the hedge fund billionaire who is also majority owner of Citadel Securities, was subject to especially intense questioning by Democratic Representative Brad Sherman, after he dodged the lawmaker’s question about whether market-makers charge all brokers equally.

Conclusion

Free trading and simple-to-use apps have made it much easier for regular investors to pour money into stocks like GameStop. In a world without international travel, live entertainment and other usual pastimes, brokerage apps such as Robinhood are drawing hordes of new users looking for both a diversion and a jackpot.

However, there is a difference between short-term trading and long-term investing. At Crystal, we believe that your clients’ portfolios should be invested with a long-term objective in mind. Get-rich-quick schemes can be deceiving.

Ensure your clients’ portfolios are diversified and that your clients allocate only to institutional hedge funds that have robust risk management frameworks, proven track records and deep teams to navigate market volatility arising during events such as these.

See which institutional hedge funds on our platform navigated the events that unfolded during the GameStop short squeeze this past January.

Join our growing community of financial advisors.