Illustration for article titled What Makes the GameStop Stock Trading Frenzy?Photo: Dev Chatterjee (Shutterstock)

You might have headlines this week about the sudden surge in stock prices for dying companies like GameStop (by 400%) and AMC (plus 375%). But what about blockbusters? Yes, they still exist as penny stocks – and they’re over 2000% from the beginning of this week too. What’s happening?

Rise of the private investor

In traditional value investing, you find an undervalued company, buy the stock while it’s cheap, and then make money when it increases in value. With these stocks, the valuation does not matter. After all, nobody expects much from GameStop – a chain of brick and mortar stores battling their way through the pandemic with an outdated business model – let alone the mummified shell of Blockbuster.

Why are these companies’ stock movements not driven by their fundamentals? Because we are really dealing with a Short sales Fight between big hedge funds and increasingly powerful and organized retailers whose influence comes from commission-free stores, the use of individual investor apps like Robinhood, and the power given to them by social media and the internet – including the popular noisy subreddit r / wallstreetbets (Self-billing: “4chan found a Bloomberg terminal”) – to work together.

Illustration for article titled What Makes the GameStop Stock Trading Frenzy?

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A series of short sales

To understand what is happening, you need to know how Short sales works. Often used by large institutional investors, short selling involves a short-term bet that a company’s stock will fall. Essentially, these investors borrow the company’s shares from a broker-dealer, sell them instantly in the market, and then buy them back when the price falls. At that point, they pocket the difference and return the shares to the broker-dealer. These are risky investments as the stocks will have to be returned to the broker-dealer at some point and there is no guarantee that a stock price will ever fall.

These institutional investors got greedy with their short sales as they shorted more than 100% of their outstanding shares for these companies (139% in the case of GameStop). This means that investors are betting more stocks than they actually have, which is very unusual. This caught the attention of retail investors and gave them the opportunity to both make money and have some pride at the expense of the big hedge funds.

The retail investor’s squeeze game

So what if a group of recreational investors invested in a short stock and raised its price? The short sellers lose a lot of money. Worse still, the original broker-dealer may request that their shares be returned immediately under a Request for additional funding – Forcing the short seller to buy back stocks that have already been sold, even if they now cost much more than they sold. And when they do, the stock price continues to rise – part of a feedback loop known as “short press.

In what has been dubbed “The Nerds’ Revenge,” individual investors are actually making money from these brief shortages, and it is simply unprepared that hedge fund managers are unprepared. Just like short selling, making money from a squeeze requires good timing and discipline, as an investor will want to sell when the short sell-back frenzy has peaked. Another strategy approved by Reddit was to call brokers and insist that they not loan out stocks to sell short – a standard customer right – which propelled the stock price even higher.

In theory, the speculation ends when enough short sellers finally cut their losses and dump the stock – but in theory, Reddit could keep a “memestock” like GameStop up for as long as they want.

Illustration for article titled What Makes the GameStop Stock Trading Frenzy?

Is it illegal?

According to Bloombergthe SEC is likely to “scrutinize” the trade, and the Finance Department says They “monitor” the situation. However, charges of market manipulation usually require evidence that investors are knowingly providing false information in order to induce other traders to buy or sell a stock. In that case, one could argue that Redditors’ dizzying YOLO motifs were actually quite transparent.

James Cox, a professor at Duke University School of Law, told Bloomberg:

“It’s an enforcement nightmare for the SEC. The question is: where does the manipulation begin and when does the trading of your own premonitions and publicizing your premonitions begin? ”

Typically, successful enforcement cases depend on the SEC, which shows investors are knowingly disseminating false information in order to induce other traders to buy or sell a stock.

As Bloomberg’s Matt Levine points outTo prosecute such a case here, the SEC would have to take unprecedented action – if they do anything at all.

Will this affect your investments?

All investments in the stock market carry some risk, and the volatility of stocks is part of that risk. However, it is not yet clear how these retail investor movements will affect traditional investors with long-term value. The more immediate concern could be that FOMO retail investors will take risky bets and lose money that they cannot afford to part with. The bottom line is that individual investors should be fully aware of the risks they are taking, especially for any investment phenomenon described in terms such as “frenzy” and “insanity”. And if you feel like using an investment app like Robinhood, check out this one CNBC post about the risks first.