What Does The GameStop Stock Manipulation Tell Us About The Stock Market?

GameStop is making headlines as shares of the company have jumped more than 300% in the past two and a half weeks. Any stock would be in the news for a jump like that, what makes GameStop different is that this increase was artificially created by market manipulators.

BACKGROUND

The first lesson Financial Advisors learn is that the single biggest factor that controls the stock market is emotion. A positive headline can create excitement which leads to investors purchasing shares which in turn drives the price up, as supply decreases. The opposite holds true as well, panic by investors can create a "run" on a stock, where there are more sellers than buyers, which leads to a price decrease.

The efficient market hypothesis states that an asset price reflects all publicly available information. Therefore, in theory, it's impossible to "beat the market" as prices will only move as new information becomes available and a free market will quickly correct any price discrepancies. Investor emotions and the efficient market hypothesis are both readily accepted theories in finance, yet they seem to work in opposition to each other.

Step in GameStop. Or to be more accurate, a group of everyday investors who understood these market movers and targeted GameStop for an expensive social experiment. GameStop as a company is largely unremarkable, a classic brick and mortar shop whose getting beat out by online retailers. In fact, wall street analysts, whose job is to forecast future potential, have consistently downgraded the company as a dying dinosaur.

SHORT SELLERS

Most people think of investing as purchasing an asset and realizing a gain when the value of the asset increases. This is the classis "buy and hold" approach to investing, championed by titans in the industry such as Warren Buffet. Buffet has his "Dairy Queen" theory - he bought and held many shares in the company because he would eat there regularly and believed in their long term value. This is the warm and fuzzy approach to investing, the opposite and sometimes dark side is known as short selling.

Short sellers don't believe in a company's long-term potential and in fact, think the company will one day lose value or will become bankrupt. They believe this so strongly, they are willing to gamble on it. The way to gain from this pessimism is known as short selling. For simplicity, short selling is where an investor "borrows" a number of shares and promises to return the same number of shares at some point in the future. If the price goes down in the future, the future shares cost less to return.

Billy doesn't believe in GameStop and wants to short the stock. He "borrows" 10 shares @ $20/share. He immediately sells those shares for $200 (10 shares @ $20/share = $200). The stock goes down to $10/share, at which point he wants to fulfill his short. He buys those 10 shares back for $100 (10 @ $10/share). He "returns" the 10 shares, fulfilling his obligation, but has netted $100 since the stock price decreased.

The Billy example illustrates how a short seller plans to make money. The important part to note is that a short seller is capped at how much they can make, the lowest a stock price can go to is $0. What if the short seller is wrong? If the price of the stock increases, the short seller is on the hook until they return the shares, meaning their potential losses are uncapped (stock price can go up infinitely). Being an uncovered short seller is the most vulnerable position for an investor.

SHORT SELLING GAMESTOP

As I mentioned, analysts have downgraded GameStop believing they are a failing business with limited revenue potential. For this reason, short sellers have flocked to GameStop awaiting what they see as the inevitable collapse. Many of these short sellers are institutional investors and hedge funds (not regular people), who rely on computer algorithms to decide when to buy and sell. As you can imagine, short sellers are not seen in the best light as they are actively rooting for companies to fail.

REDDIT

All this takes us to a Reddit forum r/WallStreetBets, an online forum with over 2 million people in the group. The forum noticed all the heavy short positions in GameStop and knew the ramifications of increasing the price: short sellers panicking and being forced to return shares. What started as a small thread, turned into a full blown campaign to purchase GameStop and artificially increase the price and hold the short sellers to the fire.

In the last few weeks the price went from $17/share to roughly $30/share, with the forum encouraging buyers to stay strong and hold. Sure enough, some short positions gave in and started buying back shares to return. The problem, there were no shares left to purchase, which caused the price to keep increasing. The result was a share price of $144 on 1/25/21. One hedge fund was $55million short on GameStop and had to redeem close to $2billion to cover those positions, effectively ending the fund.

Some Reddit-ers are up millions with the scheme, having purchased the shares at or near the bottom. Of course these are only paper gains until they actually make a sale but it shows the power of a coordinated run on an institution. This isn't the first time people have manipulated a stock price, individuals and banks have done similar things in the past. But this does show the power of technology, not only by being able to unite small investors but also how free trading apps like Robinhood can be a tool for exploitation. On top of that, computer models set to buy or sell at automatic trigger prices, will increase the momentum of movements.

Articles are already being written looking towards other stocks that are overly shorted who have the potential for a GameStop type of run. True to the efficient market hypothesis, those shares are increasing and short positions are being closed. Hedge funds won't leave themselves as naked going forward.

This certainly won't be the last example of market manipulation. As an everyday investor, its important to understand how these outside influences can affect a portfolio. The general rule of thumb is if you're hearing about an investment opportunity, it's probably already oversaturated. Being well diversified will help protect against these forces, but for a select few, there are always opportunities to profit. For most of us, the Dairy Queen model is a great way to look at investing, if you use the product and believe in the company, purchase and hold the stock. Also, focus on management, a venture capitalist will invest in a great founder, regardless of the company. Think Steve Jobs, Jeff Bezos, Elon Musk, etc., these type of individuals will be successful in any era and economy.