The GameStop Situation From a Finance Perspective

Won Yong Kim, assistant professor of finance

GameStop lost 18.8 million dollars in the third quarter of 2020. Usually, the stock price of GameStop is in the range of $20 – $55, but it declined to around $3 – $4 in early 2020. Then, it suddenly rose up to over $300 in January 2021. What happened to this company?

In order to understand this, we need to know a commonly used technique called a short sale. We know that we can make a profit if the price of stocks increases. If you are an expert investor, you can make an abnormal return, the return which beats the market based on the risk you take, by purchasing an undervalued stock. Finding it is not easy and very costly. Hence, only experienced and professional investors can take this opportunity. 

What if you find an overpriced stock, not an underpriced one? Suppose you own a stock whose current market price is $40. After the analysis, you find that its fair value should be $25. You must sell it now since the price will go down to $25. Now, what if you do not have this stock in hand? Are you going to lose the opportunity? 

People are very good at finding a way to make money. Let’s say you find someone who owns an overpriced stock and is willing to lend you a share. You borrow a share and sell it immediately. You will have $40. Since you borrowed it, you need to pay back. Wait until the stock price hits the fair price. Then, buy a share at $25 using the money you just made and return the stock to the original owner. Since you sold the stock at $40 and paid $25 to buy it back, your profit is $15. Obviously, you should pay some costs to borrow the stock, but if the borrowing cost is lower than $15, you still make money. This trading technique is called a short sale. 

This is what happened to GameStop stock. A number of investors started to buy its shares in January. Hedge funds who believed that prices were overly increased attempted to short sell. Investors in a Reddit group, r/wallstreetbets, reacted aggressively. The rebels began to buy shares of GameStop, and prices kept increasing. This was disastrous to short sellers, since prices can increase unlimitedly, the maximum loss from a short sale is also unlimited. In addition, since a short sale is a credit transaction where the seller borrows a stock and promises to pay it back, short sellers need to put more cash to avoid default. Therefore, they want to close short positions. The only way to do so is by buying shares to pay them back, which tremendously increases the demand. This makes the prices increase even higher, a phenomenon called short squeezing.

But this isn’t just about redditors making quick money. This is a collective effort to penalize the perceived evil Wall Street and teach hedge funds a lesson. The individual investors are rising up, saying “Never look down on us. We can also act together and penalize you guys!”

However, this rebellion can only continue as long as the stock prices keep increasing. Stock prices will eventually go down to fair value. When the price starts falling, as GameStop’s has, it suddenly becomes the race for who can exit earlier to realize profits and avoid losses. These days, the price is around $50, and many experts expect that it will go down further.

The ones who entered the game early and exited when the price was high are the winners. Many investors, including both individuals and institutions who shorted during the peak are another type of winners. The insiders who failed to manage the firm can be big winners since many of them sold the shares they hold when the prices rose. The losers? The ones who bought shares at $300 are now hurting. Some of them are citizens who worked together to penalize evils, at a great cost to themselves. We criticized Wall Street who received huge compensation even though their banks failed during the Great Recession. Just weeks ago, we saw the same phenomenon.