David Azzato and really the entire world seemed to stop in January to talk about a seemingly oddball topic: the stock price of a brick-and-mortar video game store that you see in nearly every mall in America. Instead of focusing on politics or the weather or sports, every news program on TV and Wall Street had turned the laser-like focus onto GameStop and a crowd of day traders on a Reddit social media subgroup.
The popular Robinhood trading app jumped into the fray at one point and enraged many of its day traders, as well as members of Congress. The public was captivated by the event because it seemed like a modern-day David and Goliath story. Individual little-guy investors were banding together and taking on some of the largest professional financial institutions on Wall Street. More than a month later, the dust still has not settled from this event. Many people are wondering if the same thing could happen again, while others are not exactly certain what happened at all. Let’s take a closer look.
GameStop: Outdated and out of shape
GameStop (GME) was a popular store for a lot of years. Formerly Babbage’s, it changed its name to GameStop in 1999. As of the start of 2021, it operated more than 5,500 stores in malls across America. The company’s financial problems started to hit in the mid-2010s. GameStop sells video game discs, but the video game market started to shift to digital storefronts. The cultural phenomenon of heading to the mall and waiting for a new video game title on its release date pretty much became a thing of the past once gamers could simply download games from a streaming service at home. Many gaming computers that you can purchase from Best Buy these days don’t even come with a disc drive, because gamers rarely purchase physical copies of PC games anymore. By March 2020, GME stock had bottomed out at $3.65 a share.
The fact that many of the malls in America were shut down through the COVID-19 pandemic didn’t help GameStop’s outlook. New investors came on board in 2020 and started to restructure GameStop’s overall business plan. The company announced in December 2020 that it would be closing over 1,000 storefronts in March 2021. By mid-January of 2021, GME stocks were trading at around $40 a share.
Hedge funds, financial pros, and other investors were listening on January 21 when Andrew Left, the founder of Citron Research, made a declaration that GameStop’s business was in a state of “terminal decline.” On the same day when GME stock closed at $43.03 per share, Left stated that he believed GME was going to plummet back down to around $20 a share. It wasn’t just people who work for the big Wall Street firms that were listening to Left, however. There was also a group of day traders on the subreddit group r/WallStreetBets that was listening.
Hedge funds short sell GameStop shares
Citron Research, Melvin Capital, and several other hedge funds short-sold GME immediately upon the rumors that the stock price was going to drop by about half. Short selling a stock, however, carries some inherent risks that are different from what you see in traditional investments.
Most investment in stocks is pretty standard: You purchase a stock at one price and then hold onto it until the price goes up. You sell at a higher price and pocket the difference as profit. Even if some catastrophe were to occur and the stock price dropped to $0 for some reason, the only money that you could lose is the initial amount that you invested in the stock. You can’t lose more than that. Short selling works differently.
When someone short sells a stock, they are betting that the stock price will drop from its current level. Here’s a simplified explanation of how short selling works:
The investor borrows a stock (or a large number of stocks) from another investor when shares are trading at a certain price. Let’s call it $10 a share for simplification purposes. So you borrow that share at $10, and there’s a set date when you have to close your position on that share (give it back to the original owner). If the share price drops to $8 and your closing date arrives, you give the share back to the original owner and pocket the $2 loss on it as your profit. The danger in short selling kicks in if your bet is wrong, however, and the share price goes up. If the share price climbs to $12, you have to give that share back to the original owner, plus you have to pay the owner the $2 that the share price increased.
Multiply that by tens of thousands of shares and millions of dollars, and it’s easy to see that short selling stock has the potential to backfire spectacularly. A lot of financial firms short-sold GME stock on January 21, anticipating an easy 50% profit. All the experts agreed that GameStop’s value was going to plummet from $40 a share to $20 a share in a short amount of time.
But the Redditors on r/WallStreetBets had a different idea.
r/WallStreetBets storms the gates
No one has pinned down a reason as to why r/WallStreetBets chose GameStop. Some probably just wanted to try to make some money, while others were a bit nihilistic and wanted to stick it to the man. Others have speculated that perhaps it was a bit of nostalgia for the outdated video game store. Back in the early 2000s, GameStop was the place to be anytime a hot new video game title was released. Perhaps some of the subreddit investors remembered those fond times from their youth and wanted to preserve GameStop?
Whatever the reason for the investment was, r/WallStreetBets members banded together and started buying up GME shares to drive the price up. Many in the group boasted and posted memes that they were spending their $600 stimulus checks to purchase GME shares. Simple supply and demand take over when something like this happens: When people start buying up shares of a stock, the price goes up.
On January 22 — one day after the head of Citron Research declared GameStop to be in “terminal decline” — GME shares jumped up to $65.01 as the markets closed. To put that into perspective, the highest price that GME stocks had ever traded previously was a record $60.78, back in December 2007.
Hedge funds and financial firms that had just short sold a tremendous amount of GME shares had just seen their worlds turned upside down by a group of Redditors who bet in the other direction.
GameStop goes viral
By January 25, the GameStop shock waves had gone viral. Elon Musk tweeted a single word that day — “Stonks!” — and suddenly everyone was paying attention to the share price of a defunct brick-and-mortar video game store. Musk’s animosity toward hedge funds is almost legendary; short-sellers on Wall Street lost more than $40 billion by betting against Tesla in 2020. Following Musk’s tweet, GME shares closed at $76.79 on January 25. Other celebrities began sharing the “Storming of the Stonks” on social media, driving further interest in the story.
The day after Musk tweeted about the event, GameStop’s share price jumped to an astonishing $147.98. For anyone who had short-sold GameStop, it was a proverbial bloodbath. As GameStop shares were fluctuating wildly, Citron Research managed to close its position when the price was in the mid-$90 range. The company suffered a staggering 100% loss.
Melvin Capital had it much worse. The hedge fund required an infusion of $3 billion from other hedge funds just to cover its losses on GameStop. And the ride wasn’t over yet.
On January 27, GameStop peaked at $347.51 a share when the markets closed. And just when the entire world started paying attention to GameStop and the r/WallStreetBets group, things started to get weird.
Trading apps squashed the little guys
What happened to GameStop’s share prices was not normal by Wall Street standards, to say the least. Stocks trading in the $20 range don’t suddenly jump in value by 1,700% in less than a week. But what outraged many members of the public and Congress was the unprecedented actions by the trading apps that the Redditors used to purchase their shares.
If you had purchased 100 shares of GME when it was selling at $40 a share on January 21 (for $4,000), you could have sold those shares for $30,000 less than a week later. Or at least you could have done that if your trading app allowed you to sell those shares.
The r/WallStreetBets investors woke up the next day to discover that Robinhood and WeBull — two of the primary smartphone apps that the group used to purchase their shares — would not allow them to sell their GME stocks. People who didn’t work for the hedge funds or investment firms on Wall Street were prevented from making the profits that their investments had created. The Redditors were locked out of their servers on Reddit for several days by Discord, so they couldn’t communicate with each other. Share prices in GME had dropped back down to $90 by February 2.
A class-action lawsuit was filed against Robinhood on January 28. In the meantime, members of Congress were outraged by Robinhood’s intervention and declared it to be market manipulation. And it was not a partisan issue. Rep. Alexandria Ocasio-Cortez (D-NY) and Sen. Ted Cruz (R-TX) are about as far apart as you can get on the ideological divide in America, and both of them condemned Robinhood’s actions.
What happens next?
It’s unclear at this point how or if financial regulators are going to change trading rules based on the “Storming of the Stonks.” More congressional hearings on the subject are planned. It could take years before the class action suit against Robinhood gets sorted out.
r/WallStreetBets group did not do anything illegal under current trading rules. They played within the rules and were prevented from realizing those potential profits by the companies running the trading apps that they used. A lot of people are still trying to make sense of everything that occurred. Angel investor and entrepreneur David Azzato published a great and easy-to-understand analysis of the GameStop incident on Medium.
Could the volatility caused in the markets by this incident happen again? The short answer is: Absolutely. No rules or regulations have changed by this point. GameStop’s share price stabilized in the $40s during much of February. It’s worth noting that on March 4, 2021, the share price closed at $132.35. But the week of March 10th, the stock is on the rise again. It’s anyone’s guess where this will end up now.