In January 2021, a short squeeze of the stock of GameStop and other publicly-traded companies made headlines. Perhaps you heard the term "short squeeze" and wondered what the heck a short squeeze is.
I’ve had a few clients reach out and ask this question so I thought we would cover it in this month’s episode. So, today I’m going to talk about what happened to cause the rapid increase in the stock price of GameStop, why it could happen again, and how it doesn’t have to affect your retirement.
I apologize for all the industry jargon I’m going to use, but there simply isn’t a way around it when discussing what happened.
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What is a Short Squeeze?
A short squeeze happens when there is excess demand for a company’s stock and not enough supply to meet that demand, causing the price of the stock to increase rapidly.
This is caused by the practice of short selling in which an investor (or short seller) borrows stocks to sell right away with the hope of buying the stocks later at a lower price.
This can cause major financial consequences for certain hedge funds and large losses for short sellers, who have to purchase the stocks at higher prices than what they received when they sold the stocks.
This is what happened with GameStop.
GameStop’s stock was heavily shorted, meaning investors were making bets that the stock would go down significantly. In 2020, GameStop became one of the most shorted stocks in the entire stock market.
Multi-billion-dollar hedge funds were betting that this stock would go down. Reddit users saw an opportunity because the Wall Street investors had put themselves in a situation of a potential short squeeze.
Investors on Reddit banned together in a forum to buy stock in GameStop all at once, thus driving the stock price up. Their hope was that these multi-billion-dollar hedge funds would lose money. And they did.
For a couple of days in January, GameStop was the most traded stock in the U.S.
At its height, on January 28, the short squeeze caused GameStop’s price to reach a pre-market value of over $500 per share, nearly 30 times the $17.25 valuation at the beginning of the month.
Adding fuel to the fire, Robinhood and other brokerages halted the buying of GameStop and other securities, later citing their inability to post sufficient collateral to execute their clients' orders.
This decision attracted criticism and accusations of market manipulation leading to class-action lawsuits.
I talked a little about Robinhood in a recent Eagle Updates newsletter. If you are not currently receiving our weekly newsletter about money, life, and how they intersect, please sign up below this article.
GameStop sells physical products, mostly in brick-and-mortar stores, and that is not a great business to be in right now. Even before COVID-19, brick-and-mortar stores were suffering due to online shopping.
GameStop’s revenues were falling for several quarters. For Wall Street investors, GameStop was a clear loser and considered a bad investment.
In 2020, an investor named Ryan Cohen sided with GameStop. He bought a 10% stake in GameStop, which made him one of the company’s largest individual shareholders.
Cohen was co-founder of the successful online company Chewy, which sells pet products and was later sold to PetSmart for $3.35 billion dollars.
Then in January 2021, Cohen joined the board of GameStop with a plan for how to make the company more digital. That got Reddit users excited.
Impact of Reddit Users
While Wall Street investors agreed GameStop was a bad investment, a group of investors on Reddit started to make a case that Wall Street was wrong.
Fundamentals and company standing don’t matter to individual investors. What matters is sentiment and how they feel about the company.
GameStop is the only brick-and-mortar store dedicated to video gaming.
The Reddit investors liked GameStop and thought the stock would go up. They thought new game consoles (like the PlayStation 5) could increase sales for GameStop.
The Bigger Reason
As a bigger reason, Reddit users wanted to take down “the man,” in this case meaning Wall Street and associated corporations that always win at the expense of mom-and-pop businesses.
Those Reddit users exploited Wall Street for their own gain.
This has the potential to happen with other stocks. There is nothing illegal about posting your opinion on the internet about investments, just like hedge fund managers do on CNBC. Wall Street has a new force to reckon with.
But we don’t need to participate in the Reddit antics that we saw in January to take a stand. A very easy first step is to stop giving your money to “the man.”
Stop supporting publicly traded brokerage firms that are required to put shareholders’ interests first and ahead of yours. Stop investing in high-cost products that tell a good story but fail to produce good results.
Typically, profiting from a short squeeze is a high-risk game and your timing would have to be impeccable. And if you were able to get it right one time, the odds of doing it again would be extremely low.
It is not a viable long-term strategy, so we will not partake in this high-stakes game, but I do hope I was able to add a bit more clarity on what the heck happened.