GameStop (ticker: GME) is having quite the year: Its stock has surged more than 750% year to date (and more than 40 times from its low in March 2020).
What is behind the incredible gains? Stellar sales growth? A transformative acquisition? New management? The answer is d) None of the above! The outsized stock price action has been driven by a coordinated effort by retail investors that created a “short squeeze” and “gamma trap” for GameStop, all organized via Reddit and Twitter.
But the frenetic activity behind the wild swings in the stock price of a once-obscure small cap company can provide valuable lessons for institutional investors about short-selling, the role of individual investors in sharp market moves, and the potential impact on institutional portfolios. This post answers a series of questions to help provide asset owners some context for this episode and insights about how they may want to assess this type of activity, as GameStop was neither the first nor will it be the last stock to be the focus of such a whirlwind.
What is Reddit?
Reddit, which claims to be the “front page of the internet,” is a massive collection of forums on which people can share news and content or comment on other people’s posts. Reddit contains more than 1 million communities known as “subreddits,” each of which covers a different topic.
One such subreddit is called r/WallStreetBets. The forum counts over 2.4 million members and hosts discussions ranging from trading strategies to individual security analysis—and lots of commiserating. The subreddit grew in popularity during the pandemic as individuals with more time, greater access to trading (via the popularity of Robinhood), and money (via the Fed stimulus, or “stimmy” in Reddit parlance) sought new forms of entertainment.
What is GameStop?
GameStop is a video game retailer with 5,000 stores and four years of declining sales, and it disclosed a net loss in the past 12-month period. The share price was as low as $3.50 in March 2020 and closed around $19 at year-end 2020, with a market capitalization of $1.3 billion.
According to Dow Jones data, GameStop began the year as one of the most-shorted companies on the major exchanges (i.e., NYSE or Nasdaq). As of Jan. 22, short interest in the company’s shares outstanding stood at 102%, according to IHS Markit data tracked by S&P Global Market Intelligence (short interest was 71.2 million shares, while GameStop has only 69.7 million shares outstanding). As of Jan. 25, the short interest increased to over 130%, with nearly $5 billion in outstanding short positions.
What is a short squeeze?
When shorting a stock, investors borrow shares and sell them, promising to return the shares in the future. Investors have to pay a fee to borrow shares and post collateral based on the borrowed shares’ value. Investors have to return the borrowed shares if the lender asks for them back. When the stock price goes up a lot, short-sellers start feeling “squeezed”—their borrowing costs go up, collateral requirements increase, and lenders may ask for their stock back. Some short sellers might capitulate and will close their positions by buying back stock. The process creates a feedback loop for rising stock prices: as the stock price goes up, short-sellers exit short positions by buying stock to surrender, and the buying action pushes the stock price up more.
What is going on with GameStop stock?
Many short-sellers believe GameStop is a declining business with limited prospects to improve. Citron Research is notable for publicly releasing research reports on short investment opportunities to drive the stock price lower. The firm was quite vocal about GameStop, betting that the current stock price was far too high.
In October 2020, members of the WallStreetBets forum encouraged others to buy shares and call options in GameStop. Some users pointed to the short sellers wagering against the stock. The calls to buy coincided with Ryan Cohen (founder of Chewy Inc.) purchasing a large stake in the company and vocally advocating company management for changes.
The share price began to rise on Jan. 11, 2021, after the company announced the addition of three new directors to its board, including Cohen. The rally accelerated in the days that followed. Shares closed on Jan. 22 at $65 (a $4.5 billion market cap), up 51% in a single day. On Jan. 25, the stock opened at $97 and rose as high as $160, all while trading was halted eight separate times for excessive volatility. The price crashed below $60 a share, finally closing at $76, a gain of 17%. On Jan. 26, the stock opened at $88 a share, rising throughout the session to close at $149, a gain of over 90% in a single day. The gains have increased the market capitalization from $1.3 billion on Jan. 1 to $10.3 billion as of Jan. 26 (and shares were trading over $215 after market close).
The stock price rose (and continued to rise) so precipitously due to coordinated buying by many retail investors at the same time. They were buying shares as well as call options, organized and catalyzed via Reddit and Twitter. Call options can magnify gains if investors have a relatively small amount of money and want to take more risk with it (such as retail traders on WallStreetBets). Meanwhile, market makers that sold these options to investors hedge their options exposure by buying GameStop shares (a practice known as delta hedging). As the stock price goes up, the market maker adjusts the hedge by buying more stock throughout the day (the change in the delta is known as gamma among options traders). Multiply this relationship by the extreme popularity of GameStop options and, with so much stock being bought as the price went up, the price kept getting pushed up. This cycle is known as a “gamma trap” to options traders.
GameStop stock became a battle between bullish (or chaotic) individual day traders from Reddit and Twitter and hedge fund short-sellers, which have been betting against the stock. The squeeze forced the firm Melvin Capital Management, a long-short hedge fund, into a bailout by Citadel and Point72 after suffering losses of $2.75 billion as a result. The fund started 2021 with $12.5 billion AUM.
What about the SEC?
While the Securities and Exchange Commission (SEC) has not commented, it will be interesting to see how the organization reacts given the uptick in these types of stock price movements in the past year. According to Section 9 of the Securities and Exchange Act of 1934 (Title 15, Chapter 2B § 78i): Manipulation of Security Prices: (a) It shall be unlawful for any person, directly, or indirectly … (2) To effect, alone or with 1 or more persons, a series of transactions in any security registered on national securities exchanges, any security not so registered, or in connection with any security-based swap or security-based swap agreement with respect to such security creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing purchase or sale of such security by others.
How does this impact institutional investors and portfolios?
GameStop price volatility will not have an outsized impact on a diversified institutional portfolio due to the company’s small size. The most recent 13F and 13D/G filings (disclosures as to what institutions own the company) as of Dec. 31, 2020, indicate that primary ownership is by passive investment managers. Interestingly, however, there is a diversity of different actively managed strategies that own GameStop, including quantitative managers, value managers, and growth managers. This demonstrates the variant perceptions of how GameStop stock was interpreted by different investors.
But price activity in GameStop represents another example in which there is a dislocation in the efficient market hypothesis. The past year saw many instances of seemingly irrational market behavior from retail investors, including the large increase in the price of Hertz after it filed for bankruptcy and the run-up in the stock price of Zoom Technologies (which is not Zoom Video Communications, the company that is actually behind the now ubiquitous video conferencing service). Over time, technical market factors and flows such as those surrounding GameStop (driven by ETFs, index funds, and retail investors) may impact equity prices more than in the recent past. The question for portfolio managers and institutional investors: Is this an anomaly, a fad—or a new paradigm in market activity going forward?