GameStop Stock | Everything You Need to Know

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Everybody’s talking about GameStop (NYSE: GME), and for good reason. In a script fit for a Hollywood movie, a swashbuckling group of NSFW chatroom traders banded together to collectively make billions and nearly take down a Wall Street hedge fund in the process.

The fallout has been immense: Melvin Capital, a $13 billion fund founded by Gabriel Plotkin, required a $2.75 billion cash injection (aka bailout) from two other hedge funds. It didn’t help as GameStop continued to explode higher, up 707% in four days alone.

Then, on January 28th popular brokers like Robinhood disabled buying of GameStop and a series of other stocks such as AMC, Koss, and Bed Bath & Beyond. With a large pool of buyers locked out (but still allowed to sell) prices plummeted.

As of January 29th, Robinhood plans to resume trading in GameStop stock, but the situation seems to change by the hour. Naturally, investors have a lot of questions. And we’re here to help you make sense of the madness by answering the most common questions.

  1. How the GameStop “short squeeze” works
  2. Why the GameStop squeeze was so massive
  3. Impacts of the GameStop short squeeze on the market
  4. What could become ‘the next GameStop’ as short squeezes spread from stock to stock?
  5. The risks investors need to be aware of (Yes, there are risks!)
  6. And, as a bonus: The Elon Musk angle

Let’s get started with the most pressing question on many investor’s minds, how did this all get started?

How the GameStop “Short Squeeze” Works

Most people believe the only way to make money in the stock market is to buy a stock and hope it goes higher. Short sellers are the exact opposite, as their aim is to make money from stock prices going down.

The mechanics of short selling are for an investor to borrow shares of stock – note the term borrow – and immediately sell those shares with the intention of buying them later at a lower price. The difference between the initial sale price and the closing (or cover) purchase is the profit.

Initially, shorting creates a liability in the form of shares owed. For that reason, shorting is riskier than “going long” because your losses are (theoretically) unlimited in the event shares continue to rise.

(When shorting your maximum gains are 100%, but your losses can be unlimited. Tough life!)

When shares rise too quickly, it can force – or “squeeze” — short-sellers into buying to cover at an unfavorable price or deposit more capital – a margin call.

Think of it this way, the financial institutions that lent out their shares start getting nervous short-sellers won’t have the money to buy back the shares they originally borrowed. So they take action to protect themselves.

If you have a significant short position, buying back becomes a self-destructing event as your purchases send the stock higher.  Remember, when short sellers are closing out their positions they’re actually buying shares which drives up the price of stocks. A vicious cycle for short sellers!

And that’s what happened with GameStop. At 140% of float (shares available for investors to trade), a short squeeze was unavoidable. When chatroom investors drove the price upward, Melvin Capital was forced to compete against the crowd to buy to cover, and its large short position led to losses in the billions.

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Why the GameStop (GME) Short Squeeze Was So Massive

Now that we’ve explained the background on shorting, let’s dive into more details about what’s happening with GameStop stock in the past week.

The chatroom investors leading the push into Gamestop had a secret weapon to take down the funds like Melvin Capital that were heavily shorting the company: call options.

These financial products give the buyer the right to buy 100 shares of GameStop at the strike price for a fraction of the cost of shares, allowing them to control a much larger pool of shares than buying them outright.

However, there was a secondary benefit to using call options: the gamma effect.

Options are valued using a complicated set of inputs called “greeks” notably including delta and gamma. Pack this away for now, we’ll circle back on these terms.

So let’s talk about market makers. Traditionally, a market maker is a matchmaker, pairing buyers and sellers. But where there are no sellers, market makers become the seller of last resort, becoming short GameStop themselves through options.

There’s just one problem: the last thing market makers want is risk from stock movements, aka delta risk.

How do they offload the risk of being short call options?

You got it – by buying shares of stock!

And in the case of GameStop where there were few sellers and many buyers, market makers had to step in frequently to sell calls and buy shares to protect themselves and remain delta neutral.

But it gets better for the swashbuckling chatroom investors…

Delta isn’t static and increases as the price of the stock increases, forcing market makers to buy even more shares.

This is the gamma effect: a chain reaction of market makers buying shares to cover their short call positions, as the stock price was going up, to prevent themselves from becoming the next Melvin Capital and on their way to the poor house!

Impacts of the GameStop Short Squeeze on the Market?

The story is still playing out, but the effects have been widespread. Melvin Capital is rumored to be on life support even after taking a bailout from Citadel, a massive hedge fund.

Unrelated stocks have felt the impact as well. Heavily shorted names have driven significantly higher as hedge funds rush to close out their positions, as fear of becoming the next Melvin Capital has shaken the core of Wall Street.

Two stocks Melvin Capital had significant long positions in – Alibaba and L Brands – have experienced increased volatility with speculation the company sold off large stakes to raise liquidity and meet margin calls from its short GameStop position.

However, the long-term ramifications are still unknown. The Securities and Exchange Commission will likely begin to police chatrooms more forcefully, although it doesn’t appear that any rules have been broken at this time.

The most significant impact will likely be among the retail traders, many of which are rich on paper now but continue to hold on to these stocks and add to their positions.

It doesn’t take a genius to understand that gains like this are unsustainable and will eventually fall to their fundamental value. Unfortunately, this will disproportionately hurt these chatroom investors.

Finally, there have been quite a few stocks that have similar characteristics that have seen their prices explode.

What Stocks Could Become ‘the Next GameStop’?

Understandably, investors are asking what will be the next GameStop? And that makes sense, considering one lucky investor turned a $25,000 investment into $40 million.

The biggest factor that propelled GameStop to stratospheric heights was its significant short interest, so investors need to find stocks that are highly-shorted.

Although GameStop was the most shorted stock on the New York Stock Exchange, there are quite a few heavily shorted names on the NYSE or Nasdaq Exchanges, and they’ve all been strong performing stocks year to date.

Company Short Interest as % of Float* YTD Return* Market Cap (B)*
National Beverage Corp. (FIZZ) 83% 85% $ 7.3
Dillards (DDS) 72% 34% $1.9
Bed Bath and Beyond (BBBY) 70% 89% $4.1
Fubo TV (FUBO) 75% 42% $2.7
GSX Techedu (GSX) 77% 103% $25.0

*As of January 29, 2021

Another reason that made GameStop a perfect target was the company was well-known and fondly remembered by the younger crowd that populates these chatrooms, which made it easier to create a sense of camaraderie and virality.

The financial media have coined a phrase “meme stocks” for this trend. Chatrooms have also boosted other meme stocks as listed below, but the percentage short is notably lower.

Company Short Interest as % of Float* YTD Return* Market Cap (B)*
AMC Entertainment (AMC) 16% 307% $2.9
Blackberry (BB) 8% 121% $8.3
Koss Corp. (KOSS) 1% 1120% $0.3

*As of January 29, 2021

Finally, these stocks were all smaller companies as denoted by market cap, allowing for less capital to move the market and create momentum. Even after these mind-boggling YTD returns, all but one company remains below $10 billion.

What Are the Risks Investors Need to be Aware of?

Quite a few. To be clear, we don’t recommend “YOLO trading,” but rather deliberately investing to fund your financial future. That said, we know eye-popping returns like this are going to inspire many to jump into the markets and we want excited and empowered investors.

However, caution is warranted. At Millennial Money, we’ve seen this mania before with dot-com stocks in the early 90s and investment properties in the early 2000s. The market will eventually turn and it’s typically those with the least to lose that end up holding the bag.

Even those that monitor their accounts frequently tend to be surprised at how quickly the next big investment can reverse and wipe out gains.

Therefore, it’s important to understand the risks you’re facing and take the proper precautions to ensure you’re not putting too much of your hard-earned money at risk. At Millennial Money, our approach is to invest 5% or less in non-traditional or speculative investments.

Make sure to map out your investment strategy in advance so that you don’t get caught up in the hype.

Bonus: Elon Musk’s GameStop

No, Musk isn’t renaming one of his SpaceX rockets GameStop…yet.

However, he joined high-profile founders and investors like Chamath Palihapitiya and Mark Cuban by expressing support for the small retail investors. For Musk, that consisted of a tweet with a single word, “Gamestonk.”

The spelling was intentional, as the word “stonk” is part of the chatroom lingo —  as is space rocket emojis to convey a stock is “going to the moon,” or making investors a lot of money.

There’s a backstory here. Musk is well-known for his derision for short sellers, going as far as calling them value destroyers and tweeting the practice should be illegal. At one point Tesla was the most-shorted stock in the market until the company won over investors and squeezed many short sellers.

One of the highest-profile Tesla shorts? You guessed it: Melvin Capital.

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