Everything you need to know to understand the GameStop phenomenon

Everything you need to know to understand the GameStop phenomenon

The GameStop frenzy on Wall Street has investors and much of the internet rapt, like a good horror movie. Everyone knows that doom is just around the corner for some key players. A lucky few will emerge stronger and the monster may be subdued, but it will eventually return for a sequel.

The cast of characters

Who is the monster and who is the hero, in this case, completely depends on your perspective.

On one hand we have a group of mostly young traders who coordinate on Reddit to make the price of the shares of companies that are in difficulty rise. This includes GameStop, but also BlackBerry, Macy’s, and AMC. At least one Reddit user posted that he had paid thousands of dollars in student loans with his GameStop earnings.

On the other side are hedge funds and short sellers, those who bet that a company’s stock will collapse. They are Wall Street’s elite, the type of investors millions of people trust to make smart decisions to boost their portfolios. Yet many millennials and Gen Z members loathe them for creating a house of cards-like financial system that led to the 2008 crash.

Now we’re potentially at the climax of this movie: GameStop is up more than 1,700% since the beginning of January. Some trading platforms, including TD Ameritrade and Robinhood, are restricting AMC and GameStop transactions. The Securities and Exchange Commission (SEC) and the White House said Wednesday they are monitoring the situation.

Here is the context you must have.

Why GameStop?

WallStreetBets (WSB), a very popular Reddit page, likes to target short sellers. If you’ve ever played craps, these are the guys who bet against the house, and their tactics, while often lucrative, have honed their reputations as bloodsuckers and other non-publishable names. (There is more on this later.)

However, it is not difficult to understand why someone would short GameStop. The company is expected to lose money this year and next. Sales growth is slow because gamers no longer need to go to the mall to buy games or consoles. With that said, some investors have argued that GameStop was seriously undervalued, especially as video games have become staples of the stay-at-home pandemic era.

GameStop’s stock surge started for a legitimate reason. The company announced on January 11 that it had added three new directors to its board, including Chewy co-founder Ryan Cohen. Investors liked that Cohen brings his digital experience to bear, something that the largely traditional GameStop desperately needs as video games go digital and shopping malls continue to fall into irrelevance.

GameStop shares were up just under 13% that day. But this was not a momentary and normal climb. Two days later, they were up 57%. Then 27%. The following week, they were up 10% twice and 51% another day. This week they were up another 18%, then 93%, and today they more than doubled.

There are two reasons for this, and both are far removed from anything related to the fundamental strength of the company. Investors who followed the Reddit group bought a bunch of GameStop options and short sellers had to buy shares to cover their losing bids.

On Wednesday, as all three major stock indices fell, GameStop finished with a staggering 134% gain.

For perspective: a year ago, a single share cost about $ 4. Now it is $ 200.

It’s not just about GameStop

A similar story is that of the actions of AMC, the chain of cinemas devastated by the pandemic.

Shares of WSB’s new toy rose more than 200% on Wednesday after Reddit board members and Robinhood investors touted the stock. The hashtag #SaveAMC was trending on Twitter.

Both AMC and GameStop rose so quickly on Wednesday that they triggered automatic stops designed to protect against volatility.

Why is it happening now?

The way people trade stocks has been altered by the rise of free apps like Robinhood. That technology has democratized investing, giving investors far removed from traditional banks free access to sophisticated trading instruments such as options.

You can pay an analyst to tell you what stocks to buy, or you can create a Reddit account and follow forums like WallStreetBets. Millions of young people are opting for the latter option, which in part explains why the sudden rises in GameStop and AMC have taken Wall Street veterans by surprise.

What is an option?

Options are bets that investors make on a stock, which allow them to buy (call option) sell it (put option) at a specified price. That allows people to bet on whether a stock will go up or down.

Investors can place relatively inexpensive option bets and sell those options as they increase in value, when the share price approaches their stake. Although buying and selling options is not the same as buying and selling stocks, large volumes of options can cause a stock to go up or down, usually because option traders buy or sell the stock itself as a hedge.

In the case of GameStop and other stocks that are targeted by WSB, traders continue to buy options, forcing investors who sell those options to hedge their bets by buying GameStop shares.

What is a short?

Short sellers are investors who bet that a stock is going to fall. They borrow shares to sell on the market with the promise to buy them back at a later date. If they win the bet, they sell high and buy low, and they leave with money in the bank.

If they lose the bet, that is called short-squeeze (known as ‘short squeeze’ in Spanish) and they often cover their losses by buying more shares in the company they bet against.

Short interest in GameStop increased at the end of the year as investors bet against the company’s earnings potential. With a mega short squeeze, the short sellers began hedging their bets, buying more shares to offset their mounting losses.

Stoking the fire

WallStreetBets, which has more than two million followers, is littered with posts applauding the stock gains. Also a not inconsiderable amount of messages of righteous indignation.

“What I think is happening is that you are making such an impact that these big shots are worried about having to get up and work for a living,” posted a group moderator this week. “That confusing feeling you are feeling is called RESPECT and it is well deserved. Wall Street no longer rules out its presence, “he added.

Elon Musk appeared to join the group Tuesday with a one-word tweet, “Gamestonk !!”, with a link to WallStreetBets. Tech investor Chamath Palihapitiya plunged into the frenzy and took call options on Tuesday but closed his position on Wednesday, he told CNBC. Palihapitiya explained that she would donate her proceeds to charity and championed the retail investing phenomenon unfolding on Reddit.

“Instead of having ‘brainstorming dinners’ or quiet conversations between hedge funds in the Hamptons, these guys have the courage to do it transparently in a forum,” he said. “What it shows is that this retail (investment) phenomenon is here to stay,” he added.

Isn’t this a bubble?

Yes it is.

There is an argument that GameStop was undervalued, but hardly anyone believes that GameStop, BlackBerry, Macy’s, AMC or any of the other companies that WSB is promoting have a rationale to support these rising stock prices. At some point, reality has to prevail.

But that’s the problem with bubbles: if you exit too early, you will lose the opportunity to charge when the price is at the top. So GameStop shares keep rising… until they don’t rise any more.

The GameStop saga of is a battle of the new school against the old school, of amateurs against professionals, of rebels against the establishment.

At the moment, the boys are winning. But, as with all bubbles, this one will burst at some point.

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