GameStop? It’s Not Just a Game…

The most popular topic on my Facebook feed now is on GameStop. But for the completely uninitiated, let us try to make sense out of what happened. Simplified post as per 30 January 2021, since the situation could evolve.

What is GameStop?

GameStop is an American videogame, consumer electronics and gaming merchandise retailer. It had been in decline since 2016 due to the digitalisation of games. Naturally, GameStop was a company that looked like it was eventually doomed to fail. Considering many of us have nostalgia about videogames, seeing it fail would be saddening, except if you could benefit from its demise.

How do you Profit From a Failing Company?

First, you can. The instrument is called a “short”.

Before describing shorts, let us describe conventional purchases of stock, i.e. we spend money to buy stock on the stock exchange at a certain price P1, and we can sell our stock at a certain price P2. It is trivial to suggest that we hope for P2 > P1 to win at the stock market. In stock market parlance, buying stock means we are playing “long”. A “short” flips these two steps around. In other words, we can “sell our stock” at a certain price P3, and then “buy back said stock” at a certain price P4. Except that we don’t own any stock of that firm in the first place. In other words, this is merely an instrument. For “short-sellers” (terminology used to describe individuals that “short” a stock), it is also a trivial inference that they profit when the buyback price P4 to be less than the selling price P3. But there are differences.

“Shorts” Can Leave You Naked

Whenever purchasing an instrument, there are certain restrictions to the product, and also statements of risk that the trader needs to be made known about. This is where taking a long position versus a short position differs. If we take a long position, and the stock crumbles overnight (i.e. it drops to 0 dollars in value), the risk is that we lose our principal. That is alright; as long as we did not owe any other entity money, we will not go bankrupt. We will feel a bad sad, but can still sleep on a bed that wouldn’t disappear overnight.

This is not the case for a short. Taking a “short” position is time-dependent, i.e. the “short” cannot last forever. When the “short” position expires, you must buy back said stock at whatever price it is on the stock market by obligation. This carries much higher risk as shown in the dummy example:

Suppose we have a stock named “Good Tech” and it retails for $200. Being a small-time trader, I “short” 200 lots of it at said price. I will earn $40,000. If the stock price drops to $100, I would earn a profit of ($200 – $100) multiplied by 200 lots, which is $20,000. Not bad for predicting a company’s decline. But what happens when the stock price rises to $2,000 when the “short” expires (or when I decide to sell it)? Well, I will have to pay ($2,000 – $200) multiplied by 200 lots, which is $360,000!! Here our losses exceed our principal. If we do not have $360,000 to pay up, we must sell other assets, such as our bed. We are not sleeping easy tonight.

If it is so Risky, Why Short?

Different stock exchanges behave differently. Some have conservative restrictions on shorting, considering its high risk. But this was not the case in GameStop. Some hedge funds believed its decline meant that shorting it consistently was positive cash flow. In other words, shorting a stock provides easy access to capital. The idea was: short an unprofitable entity, get some “easy money”, invest long in some profitable entity, earn both ways. Clearly rather greedy.

Short Squeeze

Approximately 140% of GameStop’s shares were sold short. That should alarm any regulator. The Wall Street Bets (WSB) subreddit noticed this too, and realised this was indeed anomalous. Hence, GameStop became a target of a short squeeze. In short, artificially buy so much of the stock to inflate its stock value, forcing traders adopting “short” positions to decide to cash out at a loss, or take higher potential losses when the “short” expires. This left the hedge funds who were attacked by the “short squeeze” with huge losses, considering the skyrocketing GameStop price.

Taken from Wikipedia. Note the price from 11 January (<$50) to 27 January. Note that past stock price is not indicative of future stock price.

Basically, if a fund had a short position on 28 December (approx $20), and they were caught on 26 January (approx $130), they were looking at losses of $110 per share. That quickly adds up.

The short squeeze was further reinforced by tweets from Elon Musk. In my part of the world, there were attempts to short squeeze short positions on glove companies as well (interestingly enough, they were already on the watchlist for high short magins by the Kuala Lumpur Stock Exchange in December 2020).

Who Was Happy, and Who Was Not?

(Warning! Political commentary begins here!)

Some narratives suggest that this was a “Redditors versus Wall Street” battle. Others commented this was a bunch of institutional investors taking long positions slugging it out with hedge funds taking short positions, with Redditors fuelling the fire. Many of these narratives are compelling, so let us take some time to understand them in their political context.

Among notable figures that supported the short-selling were Ted Cruz (Republican) and AOC (Democrat). They lambasted Robinhood, one of the brokers, for suspending purchases of GameStop shares. In addition to the criticism from politicians, Robinhood was sued with a class action suit due to the trading suspension. Some quarters are also looking into speculations of links between Robinhood and Melvin Capital, the initial hedge fund that racked billions of losses due to the short squeeze.

To understand why AOC and Ted Cruz, from seemingly different parties, supported WSB, one needs to steer away from traditional interpretations of the GOP and Democrats.

AOC represents a generation of young Americans that feel negatively about the establishment. In their world view, “the establishment” has led to problems such as high student debt, inability to find meaningful employment and a pessimism that they can be successful in life in an increasingly divided American society. The narrative is sometimes enhanced through the juxtaposition of the “tiny coastal elite” and “jobless student who graduated from university with mountains of debt”.

While Ted Cruz is not Donald Trump, the GOP has also learnt that Trump has energised a GOP base comprising of rural people left economically disenfranchised due to the vast disparity in influence, power and economic growth between the urban areas and rural areas. This pro-GOP section does not look too kindly at “Big Business”, which was a traditional mainstay of GOP support in the past. Energising this ground is critical in maintaining GOP relevance.

Basically, we need to look beyond traditional “GOP vs Democrat” lines, and start understanding that a significant majority of people in the US feel pessimistic about their future. Their common enemy? Suit-donning Wall Street elites that control levers of power.

The narratives were not entirely accurate though. Not all suit-donning Wall Street elites took short positions on GameStop. It was reported that BlackRock was likely to have earned billions of dollars simply because of their 13% equity stake in it. The people who work in BlackRock are also likely to be suit-donning Wall Street elites that simply bet the right way. There were elites who were (silently) happy as well.

Even among retail traders, there was a mix of results. Those that followed the WSB sub-reddit super closely likely followed a wave (very short time interval!) but those that were late to the party likely burnt themselves. Even among retail traders, not everyone was happy. This was not exactly “Redditors versus Wall Street” in reality.

Where Were the Regulators?

In the United States, the US Securities and Exchanges Commission (SEC) function as the regulatory authority for the stock exchanges we are concerned about. They issued a statement saying that the SEC was monitoring GameStop. Other politicians such as Elizabeth Warren have lashed out at the SEC for lax regulations on hedge funds. Hedge funds typically enjoy less regulation than other types of funds, which adds to the criticism revolving around regulations, especially with respect to the aggressiveness of positions they can take.

Where is Biden in All of This?

Unfortunately, Biden’s hands are tied in this debate. Biden was involved in Obama’s administration that made SEC rules more lax in 2011. Regardless of the technicalities of the SEC relaxations, it indicates some sort of back-pedalling from deregulation.

While Elizabeth Warren’s concerns over lax regulatory frameworks and oversights on hedge funds are valid, it is difficult to view this from a bureaucratic lens. Much of the media coverage on GameStop revolves around the class divide. Unfortunately, Biden is also seen as a member of the establishment.

As of time of writing (30 January 2021), Biden has not made public commentary on the GameStop situation.

Some Philosophical Thoughts

GameStop has provided a precedent that retail investors can, through speculative pressure, apply pressure against a financial entity. It is not entirely clear whether it was more of the institutional investors or Redditors or other retail traders who made the short squeeze effective. There are philosophical debates that revolve around whether the financial markets are so complicated today that the layperson is simply “led by the nose of a financial elite”. There are also debates that entertain the idea the power imbalance between Main Street and Wall Street should be re-evaluated, and GameStop shows a proof-of-concept that targetted Wall Street entities can be impacted through the collective actions of other agents. Perhaps the over-aggression from hedge funds border on being irresponsible to their clients owing to the excessively high risk they sometimes take.

However, from a macro view this is not exactly all that rosy. Business confidence is an output of a stable financial system. These include questions like whether debt issued can be returned. Excessive “bad debt” was what led to the domino effects in 2008 to 2009. GameStop is not likely to deliver a recession, but such “short squeezing” of overly shorted stocks inevitably gives rise to domino effects with hedge funds trying to sell capital assets to salvage their short position. Is that destabilising? Definitely. But perhaps it was never sensible to be so aggressive with instruments that expose their clients to losing money far beyond their principal.

But GameStop perhaps also unravels how infinite human greed can be. Beyond the “class wars” we talk about, it also made me reflect on my own humble portfolio. When thinking of financial targets, we often get distracted by seductive ideas of trading in instruments that look wildly profitable. But we sometimes forget the risk involved in them as well. The good adage in finance, do your own due diligence, while dated, remains accurate. But maybe it is also important to understand the ends beyond the means of acquiring whatever wealth we set out to achieve. Money is important, for without money we have no resources to navigate the world. And people would not reject an extra dollar if it were given to them free. But money alone provides no philosophical direction. It is up to you to decide on the types of rewards you want, the risks you can take, and to make sure you do not burn the fingers of yourself and your loved ones. If we mock the hedge fund that went bust due to their excessive greed shorting GameStop, we should not recreate the circumstances that will lead us to sacrifice our loved ones.

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