Here’s a quick guide to the market frenzy you’ve seen in the headlines.
What is GameStop and why does everyone care?
GameStop is a brick-and-mortar video game chain that hit hard times in the pandemic. Like many distressed companies, it was targeted by short sellers betting that the stock’s price would go down.1
Basically, short sellers do the opposite of most investors. They try to make money when a stock’s price falls. They borrow shares from their brokerage for a fee, immediately sell them, and plan to buy them back later at a lower price when the price falls. Shorting is a strategy used by certain types of hedge funds.
What’s a short squeeze?
Shorting stocks is risky since any positive news or interest in a company can drive the stock’s price up. When short sellers bet wrong and a stock’s price rises, they can be forced to buy shares at higher prices to cover their losses (or put up more collateral).
A squeeze happens when short sellers scramble to buy shares to cover their positions when the stock price is rising. The more investors who buy and hold those shares, the harder it is for short sellers to find shares to buy (exposing them to potentially huge losses).
Where does Reddit come in?
After it became clear that short sellers were betting on GameStop’s demise, the company became the focus of amateur traders on the popular WallStreetBets forum on Reddit, a popular community of chatrooms and forums.
By banding together and coordinating buying activity, these small-time traders boosted the stock’s price far above what the company’s financial fundamentals support, putting pressure on the hedge funds betting the other way.2
Why did the stock go viral?
Social media chatter, combined with free trading apps like Robinhood, a bull market, and new investors with time on their hands, created a frenzy in these stocks.
Is it illegal?
Regulators have not definitively ruled on that. Although retail traders are making speculative bets, it likely does not rise to the level of illegal market manipulation. However, trading has been restricted in certain names by brokerage platforms.
Is this David vs. Goliath?
The battle between gleeful amateurs pushing prices up and hedge funds scrambling to force prices down has led to some of the highest volume trading days on record and cost short sellers billions.3
Many small traders are angry at the perception that Wall Street is pulling strings and using their connections to hurt mom-and-pop investors. They see this as an opportunity to stick it to the big-money pros by using their own strategies against them.
So, should I be investing in GameStop?
No. GameStop’s stock is massively inflated and trading has been halted multiple times because of its meteoric rise.4 At this point, it looks like some investors are buying just to say they were there.
Many GameStop holders will end up losing most of their investment. It has already come down from its loftiest highs as of this writing.
Why are people angry at Robinhood?
Amidst the buying frenzy, Robinhood and other popular brokerage platforms suddenly restricted trading on several red-hot stocks, including GameStop.5
Protests erupted from investors, many market pros, lawmakers, and more.
What are the implications of this frenzy?
There’s no predicting the future, a few things are likely. Most bubble-like speculations end naturally when the euphoria turns to panic, folks start selling, and the price crashes. However, it’s also possible that regulators will step in if they think there’s risk to markets (or they see too many investors getting hurt).
But all market participants will be left with some pressing questions once the dust settles:
Will social media traders continue to drive big market moves?
Do platforms have the right to arbitrarily decide customers cannot trade?
Are coordinated moves by small investors a danger to markets?
Should regulators be watching hedge funds more closely?
What can investors learn from this?
Don’t follow the latest fads or act on rumors. As renowned investor Benjamin Graham once said, “In the short run, the market is a voting machine, but in the long run, the market is a weighing machine.” This means that for a brief while, frothy markets can stay that way, as irrational as they may seem, because people are making unwise decisions. It’s like a casino in that respect. Sure, you can strike it big and get very lucky once in a while, but odds are you’ll lose most of the time. Over the long run, though, markets usually get things right, and investors can make a competitive return by investing, not speculating, in companies in solid industries that grow their earnings over time.
Please consult your Azzad advisor if you have further questions.
1 https://www.morningstar.com/articles/1019249/what-the-heck-is-going-on-with-gamestop
3 https://www.ft.com/content/56658052-76fe-4910-8cb7-810039753f7c
4 https://www.cnbc.com/2021/01/28/robinhood-customer-sues-trading-app-over-gamestop-restrictions.html