If you follow the markets, you were privy to a seemingly once-in-a-lifetime occurrence of the “little guys” sticking it to the big hedge funds. Curious to know the story behind Gamestop? Value of Stocks is here to feed your mind.
The Story Behind Gamestop
Nobody would have thought that Gamestop (NYSE: GME) would be a topic of conversation worldwide. The small retail company focused on gaming is the hottest stock of the moment.
The story behind Gamestop is compelling: a group of small retail investors mainly in Reddit’s subsection r/wallstreetbets has shaken the whole financial world. Gamestop has been targeted by many hedge funds who after carefully analyzing the company, have concluded that it was highly likely that it would go bankrupt. Which in a way it is a fair assessment. Although a very interesting business to be in during the early 2000’s, similarly to what happened with BlockBuster is seems poised to cease operations at some point in the future.
Since games are now accessible online and consoles offer the possibility to buy them virtually, the physical games industry is slowly dying. Despite that, Gamestop’s balance sheets show that the company won’t go bankrupt so easily. Though sales have tanked due to corona and the lockdowns, Gamestop still holds over $445 million in cash and equivalents.
- Short Interest
The short interest on the stock has been one of the reasons the short squeeze was possible. Up until early February, Gamestop had a short interest of over 100%. Meaning that there were more shares sold short than there are shares outstanding. Many people wonder how that is even possible.
Let’s put it this way, when someone shorts a stock, they borrow it and are obliged to return it. For that privelge, they pay interest on the borrowed stock.
When the stock is sold short, essentially there is another buyer for those shares. Although the number of shares outstanding remains unchanged, the number of shares being traded and circulating around the market increases.
Some of the users of Wallstreetbets noticed that the high level of short interest could be an interesting short squeeze situation. Where the risk was relatively low and the potential upside was tremendous.
- Gamestop Goes Viral
To orchestrate a short squeeze it requires a lot of capital. Something that is inaccessible to most retail investors. Although when those retail investors combine efforts, they can act as a group and successfully push the prices so high that Hedge Funds with short positions suffered terrible losses.
Melvin Capital was one of the most affected and was forced to close its short position on Gamestop, requiring some of its investors to intervene and inject capital in the firm to cover its massive losses. In January the losses attributed to Gamestop short-sellers are estimated at nearly $20 billion.
- Hedge Funds Losses
Gamestop was not the only targeted short squeeze. AMC Entertainment (NYSE: AMC) was also one of the targets. Since the pandemic started, movie theatre operators have been struggling to make ends meet. Among the short squeeze targets we find struggling companies, most of them with negative earnings, either influenced by the pandemic, or struggling for a number of years. The estimation of total losses attributed to these multiple short squeezes is somewhere in the vicinity of $70 billion.
- RobinHood and other brokers
The surge in price of Gamestop created an unprecedented situation for multiple brokers. Retail investors using brokers such as Robinhood and Interactive Brokers were forced to cease or limit the trading in multiple stocks. Controversial measures had to be taken to assure the stability of the system as a whole.
Brokers are ultimately liable to some of the customer’s losses if they can’t post collateral. The possible losses not only from funds but from retail investors speculating in options posed a big threat to brokers. Ultimately some brokers appear to be undercapitalized and when clearing houses forced them to post collateral, they didn’t have the necessary liquidity. This was the reason customers were forced to limit the transactions of certain stocks.
Robinhood has been terribly affected and the situation escalated to a point of no return. The damage to its reputation has been such that the company will come out of this situation dramatically. Robinhood offers commission free trading but that comes at a cost. Brokers just like any business require revenues and profits to continue operating. Robinhood achieves this by selling its order flow to Citadel. Citadel represents over 40% of Robinhood’s revenue.
- Financial System Close to Collapse
Most investors don’t understand how the financial system was close to collapsing on the week Gamestop’s stock went ballistic. The increased amount of volatility, coupled with the fact that many retail investors were trading in margin, set them up for unlimited losses. These losses would have to be covered by the brokers if the retail investors could not come up with the necssary capital.
Some retail investors were selling puts to open a position, and setting themselves up to tremendous losses once the stock started heading down. Naturally, brokers like Robinhood would be able to cover some of those losses but only to a certain extent. The most daunting scenario would be that the broker incurs large losses, which then takes away all of its liquidity, and that could potentially lead to bankruptcy. Which at this point it could send the global economy tumbling. In this scenario, Robinhood would have been the first domino that started the toppling.
- It Was Never a Fair Game
The idea that a group of retail investors was somehow going to take Wall Street hedge funds directly is simply ludicrous. It would be the same as a team of amateur soccer players taking on one of the most well-established professional teams. It is simply impossible to win.
The amateurs may score some goals, but ultimately the professionals are expected to win. That is what the Gamestop debacle was all about. Retail investors managed to spike up the price, but only momentarily. Once reality hit and most of the pumpers had shown their true “paper hands”, transforming their paper profits into capital gains.
What most retail investors did not understand at the time, was the fact that as the stock price went up, instead of directly covering their shorts, most hedge funds just kept trading the momentum. They knew the price was bound to collapse at a certain time. So they just sold a bunch of calls way out of the money. This ensured that they received a hefty premium for something that was nearly impossible to happen.
Retail investors driven by the Gamestop frenzy and mania just kept bidding up the price of calls, not realizing that on the other side of the trade were the Hedge Funds they so desperately wanted to beat. If you are starting your investment journey you should be aware of the most common investment mistakes.
- The Consequences
It is still unclear at this point in time how the whole Gamestop story will end. On one point, some of the shorts will need to be covered. On another hand, some investors and traders looking to book a fast profit, might close their positions and that can put some downward pressure on the price.
From a regulatory standpoint, it is unclear what the SEC will do. It is also unclear what stand the Biden administration will take on the whole issue. Given that the story is very relatable, it demands a precautionary approach.
From the broker’s perspective, Robinhood comes out of this story with its reputation in shambles. Once one of the most revered brokers for its low commission and easy to use platform. Many retail investors will no longer be trading with Robinhood, which according to their view has turned into the Nottingham Sheriff.
Disclosure: I have no position in any of the stocks mentioned.
Author bio: Value of Stocks is an independent financial information provider. Focused on analyzing stocks with a value investing approach. Our main goal is to help investors make better investment decisions.