Everything you need to know about the GameStop-Reddit Saga

Here’s what you need to know about the incredible fate of a company that had been in decline for years, until a group of Internet users decided to change the situation.

What is GameStop?

GameStop is the American equivalent of the EB Games stores we find in Canadian shopping malls. Customers go there to get a new gaming console, buy or trade games, or just to chat about geek stuff with the staff. I don’t need to tell you that this business model has serious flaws to thrive in both the economic and pandemic context, especially knowing that GameStop’s customer base is already quite accustomed to online technologies and consumption.

From a financial point of view, from 2002 to 2020, GameStop shares, which are traded on the New York Stock Exchange, never reached $70. Since 2014, it was experiencing a quiet decline, without making too many waves. The trend was more pronounced in 2020, with a very difficult year due to shopping malls being closed. For the first 8 months 2020, GameStop’s share price fluctuated between $3 and $6.

And then, in January 2021, it started to rise at an incredibly rapid pace, even approaching $500!

This dizzying rise made many people smile, but for some hedge funds, it was a disaster.

What is a hedge fund?

Basically, these are funds that use highly sophisticated financial tools to generate returns. Unlike mutual funds, which are widely available to small investors, hedge funds do not necessarily seek to inflate the performance of their portfolio by identifying stocks with strong growth potential. Sometimes, it’s even the exact opposite they seek, by exploiting flaws in the market, such as an overvalued stock. Short selling is a typical example of that.

GameStop short selling

A short sale on the stock market is the equivalent of betting on the drop in the price of a share.

Until recently, all signs pointed at the continued decline of GameStop in 2021, which explains why the stock was an interesting ”prey” for hedge funds to bet against. Two funds started to short GameStop massively.

Here is an oversimplified explanation of the shorting of GameStop by hedge funds, if it had happened as expected.

• The hedge fund asks its broker to lend it shares of GameStop. (let’s say 1000 shares for the purpose of the cause)
• The broker accepts on the condition that they are returned to him at a later date.
• Meanwhile, the hedge fund sells the 1000 shares for $10 each (fictitious price for the example only). Theoretically, the fund now has $10,000 (1000 shares at $10).
• Time passes and it is time for the hedge fund to close its position, i.e., give back the 1000 shares it borrowed.
• As expected, GameStop’s stock continued to fall in the meantime, ending up at $2. The fund buys 1000 shares at $2 and gives them back to its broker as agreed.
• There you go! That’s how our fund made $8000 ($10,000-$2,000).

The harshest critics of short-selling claim that, at best, this kind of speculation creates no value, and at worst, it creates unfair and unjustified downward pressure on the price of a share.

It’s like a self-fulfilling prophecy: when a large hedge fund bets heavily on the fall of a stock, other investors will want to pull out too. As a result, the price only goes down furthermore, which benefits the hedge funds even more. It can sometimes be quite difficult to stop the vicious cycle, even if the financial and operational reality of a company does not justify the entire collapse of its market capitalization.

However, as we now know, nothing went as planned on this short. Some hedge funds have paid quite a hefty price because of a short squeeze, orchestrated by a group of finance-loving Internet users on Reddit.

The short squeeze of the Reddit wallstreetbets community

If you’re not familiar with the Reddit universe, think of it as a kind of Facebook, but more anonymous, geekier and weirder.

The wallstreetbets forum is a place where finance lovers exchange tips, discuss the market and share stock market memes. Recently, the information that hedge funds were shorting GameStop massively started to . From this, a movement was born, partly out of love for this troubled retail chain, and most likely also to teach a lesson to the very rich hedge funds.

The idea is simple: if a large number of forum members buy shares of GameStop, the sudden demand will cause strong upward pressure on its price. Which will create the opposite snowball effect of the short. Without going into the full details of the mechanism, let’s just say that the operation was a great success: on January 27 alone, GameStop’s market capitalization climbed by 10 billion.

Several reasons pushed tons of small investors to buy GameStop. Some believe that the company has a good chance of getting back on its feet, in addition to nostalgia for the store where they spent their Saturday afternoons as teenagers. Of course, for others, it was above all the perfect opportunity to teach an extremely costly lesson to hedge funds, which they perceive as financial scavengers used by the mega-rich.

Robinhood: has the trading platform betrayed its ideals?

Robinhood is a trading platform that was highly valued and used by members of the Reddit financial forum. As its name suggests, all its branding revolves around the idea of a noble and fair mission: to give small investors the chance to compete and have access to the same services as the bigger ones.

Recent events have shown that branding has its limits. In a highly controversial decision, Robinhood decided to momentarily block purchases of GameStop stock, thus slowing the rise in its price.

For many, this was a sign that the trading platform was changing the rules of the game, when the small players were winning for once. Obviously, the reality is not that simple.

What can we take away from this whole story?

This affair is far from over, but I will allow myself these remarks to conclude.

It’s mainly the lawyers who will come out of it richer because the only guaranty in this story are the lawsuits ahead from all sides.

Through it all, GameStop’s action is still at a ridiculously high price. Let’s face it, despite all the nostalgia, the company’s business model doesn’t seem ready to survive the digital shift forever.

It will be interesting to see if other communities of small investors will take shape to become major players in the investment world. Stock markets were created long before social networks, but it seems inevitable that they will increasingly shape major elements of finance.

And finally, will this affair push the authorities to review and more strictly regulate certain financial tools such as short-selling, which are usually accessible only to a minority, in order to limit their more harmful aspects?