There is a paradigm shift occurring in the stock market from which there may be a point of no return. On one side is the old guard of Wall Street: hedge funds, established financial institutions, and analysts who have built their careers in the finance industry. On the other side is retail investors: the so-called “little guy,” “unsophisticated investors,” and individuals with access to an unprecedented amount of information but little formal finance experience. Champions of the “little guy” make them out to be David slaying the Goliaths of Wall Street that have historically run the economy. The Internet is their sword and Reddit their arrows, while they strike at the heart of the giant before them to upend the stock market as we know it.
The spectacle that unfolded this week centered on GameStop ($GME), as users on the popular subreddit r/wallstreetbets noticed that GME was being shorted by hedge funds. To understand the significance of this, we first have to know what shorting a stock means. Shorting is essentially a bet against a stock. A trader, either individual or institutional like a hedge fund, can borrow a stock for free and then immediately sell it to a buyer at the current price. The trader will then buy the same stock at a later time at the prevailing price to return to the original lender. If the stock price declines from when the trader sells the stock to the third party to when they repurchase that stock and return to the original lender, then they can pocket the difference as profit. For example, if I borrow Stock X for free, sell to a third party for $20, repurchase that stock two weeks later at $10, then return the stock to the original lender, then my profit will be $10. However, if the price increases from $20 to $30, then I will have to purchase at the prevailing price and I will lose $10. Shorting is essentially a bet against a stock: it is in my interest that the company fails, because I will then make money. Hedge funds use this tactic to make unseemly amounts of money, by shorting millions of stocks that their analysts believe will fail for various reasons.
GME was one of those stocks. GameStop is by all accounts a failing company. It is a brick-and-mortar retail at a time when more customers shop online and gamers often download video games rather than buy physical discs. Hedge funds such as Melvin Capital bet billions of dollars that GME would fall. Reddit users, however, noticed that these firms shorted GME, among others, and banded together to defy their predictions. Stock prices go up and down all the time due to myriad factors: one of those factors is trading volume. Simply put, if more traders buy a stock than sell it at any given time, the price will go up, and vice-versa. Through sheer numbers, retail investors banded together and began buying GME en masse, putting the stock on an unprecedented tear. On January 4, the first trading day of 2021, GME opened at a reasonable $19/share. On January 29, it hit a high of $483/share, an astounding rise of over 2400%. And the coup de grâce for hedge funds was that they had to repurchase the shares they borrowed at higher prices, thus pushing GME even higher. This is called a short squeeze, and the Davids of the investing world executed it perfectly. Hedge funds lost billions of dollars on a stock they saw as a sure profit just a few weeks ago. Goliath had fallen.
Melvin Capital alone reportedly lost more than 50% in January and required cash inflows from other hedge funds just to stay afloat. Individual investors, on the other hand, have found new riches by sticking with GME and they have so far demonstrated solidarity by sticking with the stock to keep its share price sky high. The “unsophisticated investor” has outsmarted the smart guys and have beaten them at their own game.
It remains to be seen where this story will end. At the time of posting this article, GME was trading at approximately $100 a share, a far cry from its peak. But the Reddit trade has already demonstrated its influence and so long as trading information remains readily available on the Internet, there is nothing to stop similar events happening with other stocks going forward. Hedge funds will certainly have to take this into account. It is fair to say the business of shorting stocks has fundamentally changed.
