GameStop (GME) has been front and center in the news over the last week, but what has transpired is not an isolated incident, nor will it be the last. Before I explain what is going on, let me begin with a very simple primer on the stock market. The stock market in its most basic form is a market of buyers and sellers. This is how the stock market operates. You cannot buy a stock without a seller on the other end of the transaction and vice-versa. When you overlay the economics of supply and demand, this becomes one of the drivers of stock price movement.
For purposes of this explanation, I am not going to cover any sources of stock price movement, other than supply and demand. The stock market is a venue where one can potentially make money buying (long) a stock or selling (short) a stock. I am going to focus solely on buyers and sellers to explain what is happening in the stock market around stocks like GME.
Buying versus selling and shorting versus buying related to stock transactions
Most of the people I speak with fully understand the concept of buying, or going long, a stock. You buy a stock with the hope that it will move higher and thus it can be sold at a higher price for a profit. When one buys a stock, with the anticipation that it will move higher, that person is long the stock. But note the order of the transactions – the first operation is a buy, and the second operation is a sell, in that order. This is an example of a completed transaction.
The concept of shorting, which is the exact opposite of what I just described, is a bit more difficult to comprehend. To put shorting into the simplest terms, you are selling the stock first (shorting), hoping its price will move lower and you can buy it (buy to cover) at a profit. I am often asked, how can you sell something you do not own? Without digging too deep into an explanation, you are essentially borrowing shares from someone that currently owns those shares and that ‘borrow’ is facilitated through the institution you are trading with (a couple examples that have been in the media are Robinhood, Fidelity, TD Ameritrade, etc. Please note: this is not a recommendation of any of these platforms. These are just an examples). The institution borrows the stock from another client that currently owns it in their portfolio and lends it to the short seller. Remember, there are millions and millions of those shares to transact in from many of the publicly traded companies, but the amount of shares a company has available to transact in, or float, is finite.
Here are a couple of hypothetical examples:
- Long Buyer: Let’s say you buy one share of ABC stock (hypothetical stock) at $100. Your investment cost you $100 to obtain this single share. If this stock went up to $120, and you sold, you would have a profit of $20 and $120 in your pocket. Conversely, if the stock went to $80, and you sold, you would have realized a loss of $20 and now only have $80 in your pocket, instead of $100. But your maximum potential loss in this example is $100. If you purchased the stock for $100 and the company went out of business, you would lose your $100. You cannot lose more than your original investment as a buyer.
- Short Seller: Using the same hypothetical ABC stock that trades at $100 per share, let’s say that you short one share of the stock at $100. When you short, you are receiving cash for the amount you shorted, in this case $100. If the stock went up to $120, and you buy to cover, you must pay $120 to close out your short. In this example you received $100 initially, but then spent $120 to get yourself out of the position, thus costing you an additional $20, resulting in a loss. Conversely, if the stock went down to $80, you received $100 when you shorted the stock, but you only need to spend $80 to close out the transaction, thus you are realizing a gain of $20. The most important fact to note is that when shorting, your maximum potential downside is unlimited. This is because there is no limit to how high a stock price can go. This hypothetical $100 stock could go to $1,000 or $2,000 or any number. You must purchase at those levels to close out your short.
I mentioned that there was a finite supply of a company’s stock (i.e., GME has 69.75 MM shares available, according to MarketWatch). Let’s shift the focus to supply and demand. If someone wants more of something, what typically happens to its price? It should go higher, of course. Think about this in the context of the hot gift idea around the holidays. This past year, I remember PlayStation 5 was the must-have and hard-to-find gift. Those lucky few that got their hands on one at retail price were able to then put it on eBay and turn a profit. In summary, there was a limited supply that exceeded the demand of the item, which caused the price to move higher in the secondary market (which is eBay in this example).
As this relates to GME, there have been forums, such as r/wallstreetbets on Reddit (a popular social media site), that have served as a catalyst to bring the masses together and create demand. On the flip side, there were some institutional investors, hedge funds and the like, that had large short positions in the stock or were betting on it failing. The activity that the Reddit forum generated was largely in favor of buying and holding the stock, but when done in a large group, this caused the price to move drastically higher. As you can see in the below chart, the stock opened the year at $17.25 and has traded as high as $483.00. In addition, it is fluctuating over +/- $100 a day!
This price action creates a dynamic called short squeeze. The stock moving higher is causing large losses for those that are short GME and thus, they are buying to cover their position in order to cut their losses. But if the institution must buy to cover, they are adding to the current buying activity or demand. What you end up with is a feedback loop that only continues to exaggerate the situation. Buying begets more buying and continues to move the stock higher. Now, GME is on the nightly news and on the average individual’s radar. The feedback loop continues as Robinhood is now the most downloaded app in the App Store and more people jump on the train. The feedback loop continues, so demand continues.
Margin, or the ability to borrow money from the financial institution, is another catalyst. Investors can transact on margin, which simply means that they do not need to put up 100% of the cash when a trade is made. This is also referred to as leveraging. Because trades can be done with borrowed money, this only further exaggerates potential profit or loss. In the GME example, there have been margin calls, which means that the investor must put up additional capital or close their trade out, making the bet whole. The feedback loop continues.
Finally, there is the options market, which only adds another layer of betting on the stock. With options, there is no stock exchanging hands until the option expires. I will not go into detail on options, but it is simply another layer of betting on the underlying stock and exaggerates the movements. It is an instrument that is used to make a bet on the direction of the stock. The options market has been causing a gamma squeeze on GME, which means that it has caused more purchasing activity in the stock. The feedback loop continues.
In summary, there are several items at play here:
- margin is attractive tool due to historically low interest rates,
- the ability to trade with borrowed money,
- an extraordinary number of people downloading apps and trading from their cellphones, and
- retail investors following a trend on Reddit, which has resulted in both a short squeeze and gamma squeeze.
This activity has exaggerated a stock that appeared to be on the cusp of bankruptcy. Unless something fundamentally changes with GME, their business model remains the same. If it stays the same, it is likely only a matter of time before the stock reverts to trading as if it were on the cusp of bankruptcy again. For now, the feedback loop will continue as more and more people are on the train.