Short squeeze madness: 3 things you can learn from GameStop's stock going up 345% in 3 weeks

PHOTO: Unsplash

About four months ago, GameStop Corp’s stock price was just $6. It was also one of the most shorted stocks in the US stock market, with more than 138 per cent of its traded/float shares sold short.

If you are wondering why it’s possible to borrow more shares than what is available, here is a quick explanation:

  • For example, a listed company has 20 outstanding float shares.
  • Broker W buys 20 stocks of the company and holds a long position on them.
  • Broker X borrows shares from broker W and sells short to Broker Y.
  • Broker X then borrows another 20 shares from Broker Y and sell short to broker Z.
  • As a result, there are not 40 shares sold short on the 20 outstanding shares.

But, the company’s fortunes and its stock price changed dramatically recently.

After a 209 per cent rally in 2020, GameStop is now up 345 per cent year to date.

PHOTO: Google

The stock jumped as much as 145 per cent on Monday (Jan 25, 2021) in a turbulent trading session with nine trading halts.

This jump is believed to have been partly fueled by bullish retail investors led by the members of the online forum r/WallStreetBets subreddit.

The utter madness of it all is just fascinating to watch.

But, there are some investing lessons you can learn from this situation.

Here’s what you need to know!

GameStop’s short squeeze

Long story short, this is a battle fought between retail and institutional investors.

Last year, many influential r/WallStreetBets subreddit users picked up that a majority of GameStop’s shares were being shorted.

Things started brewing when user u/DeepF*****gValue posted about his GameStop calls that went up by about 200 per cent in Sep 2019.

PHOTO: Reddit/u/DeepF******gValue ​​​​​​

This post did not pick up steam until another influential subreddit user u/Senior_Hedgehog posted on Apr 13, 2020 about his investment thesis on the company.

PHOTO:  Reddit/u/Senior_Hedgehog

In the post, Reddit user u/Senior_Hedgehog highlighted that about 84 per cent of GameStop’s shares were being shorted.

Interestingly enough Micheal Burry of The Big Short fame held 3.5 million shares of the company in a long position.

With so much of the company’s shares being shorted by many established Wall Street institutional investors, u/Senior_hedghod was convinced that if enough Reddit users bought up the company’s stock, it could cause its share price to increase and trigger a short squeeze.

FYI: A short squeeze happens when a stock’s price unexpectedly rises at a rapid rate. Investors who hold a short position in the stock are ‘squeezed’ as they have to cover their positions and buy up more of the stocks.

This in turn increases the stock’s price even further. Subsequently, this may even trigger additional margin calls and short covering for investors shorting the stock, further driving up the price in a brutal feedback loop.

This short squeeze post was convincing enough for people to take action, with shares of the company went up by 22 per cent the day u/Senior_Hedgehog’s post went out.

The pitch got even more convincing when Ryan Cohen, the co-founder of successful pet food and pet products company Chewy.Inc revealed that he acquired a 5.8 million-share stake in GameStop on Aug 31, 2020.

This saw the company’s shares skyrocketing as much as 27 per cent that day.

All this momentum started building in the r/WallStreetBets community, which has about 2.3 million subscribers (at time of writing) and GameStop was turned into a meme stock as investors continue pouring money in.

This has played a part in triggering the company’s meteoric rise in price despite its fundamentals not improving much.

Clearly, the current share price and valuation levels are quite detached from the company’s fundamentals. This means that the stock is more than likely to drop to a much lower normal/fair valuation driven by its fundamentals.

For more insight on this, you can check out my colleague Sudhan’s analysis of GameStop Corp:

PHOTO: Seedly

In an interview with CNBC, Tesley Advisory Group analyst Joseph Feldman stated that:

“The sudden, sharp surge in GameStop’s share price and valuation likely has been fueled by a short squeeze, given the high short interest (still +100 per cent), and, to a lesser degree, speculation by retail investors on forecasts for the new gaming cycle and the involvement of activist RC Ventures,” he wrote.

“We believe the current share price and valuation levels are not sustainable, and we expect the shares to return to a more normal/fair valuation driven by the fundamentals.”

This may have triggered the short squeeze that is unfolding now as more investors pile into GameStop’s stock.

1. Shorting stocks is an infinitely risk affair

As the many institutional investors who are betting against GameStop would attest, shorting is infinitely risky.

Financial analytics company S3 Partners estimates that mark-to-market losses for investors who are shorting the company on a year-to-date basis reached US$3.3 billion (S$4.3 billion) when the stock market closed on Friday (Jan 23, 2021).

For the uninitiated, here is an explanation of the stock shorting process.

The first step would be to borrow stocks from a broker as you are betting that the price of the stock will go down,

Let’s say you borrowed 100 stocks of a company from a broker with a price of $1. It is important to note that you are not spending any money as you are just borrowing the stocks.

Do note that when shorting, you are required to return the borrowed stocks to the broker on a date set by the broker.

Next, you go and sell the shares to somebody and get $100 for your efforts.

Instead of returning $100 to the broker for lending the shares, you wait for the share price to drop to let’s say $0.50 cents a share. This enables you to buy the 100 shares for just $50 to return to your broker.

As a result, you have just made $50 in profit for shorting the stock.

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Sounds easy?

Not so fast.

It is important to note that although shorting a stock can provide gains, your losses are potentially infinite.

If you are shorting a stock and its price goes up beyond 100 per cent , you could potentially lose 100 per cent of the capital you put in to buy the stock and more.

For example, let’s say the stock price for the company you shorted went up by 200 per cent to $2 a stock. You end up losing all your initial capital ($100) and an additional $100 as you have to buy the stocks back at the increased price to return to the broker.

This is because you are required to return your shorted stocks to the broker at a set time and are forced to buy the stocks at whatever price you could get them to return the broker.

As such, your loses are potentially unlimited if you do not close your position as the price of the stock you short can continue going up, deepening your losses.

If you do not have enough in your account to cover this loss and falls under maintenance, brokers will invoke a margin call and force you to buy more stocks to cover your short position.

Also, if you hold a huge short position, there may not be enough traded stocks to quickly exit your position.

This can result in the above mentioned short squeeze.

The worse part?

Shorting stocks might not be a good investment even if it ‘pays’ off as some stocks take years to fall in price. This means that you will only get a tiny annualised return over the years.

2. The markets can remain irrational longer than you can remain solvent

Like influential economist, John Maynard Keynes once said:

“The markets can remain irrational longer than you can remain solvent.”

I would admit, there is money to be made if you gambled and bought GameStop stocks.

Some r/WallStreetBets users like u/dumbledoreRothIRA posted about his massive gains from buying GameStop stocks.

PHOTO: Reddit/u/dumbeldoreRothIRA

u/DumbledoreRothIRA claims to have made about US$300.000 (~$400,000) when GME shot up to US$108 on Monday (25 Jan 2021).

Another user claims that he/she paid off their US$23,500 (~$31,200) student loan debt with their profits from buying the company’s stocks

There is a very David vs Goliath tone to this whole situation.

On the surface, it looks like a group of everyday folk have banded together to take down the Goliath that is Wall Street’s group of institutional short-sellers: a ruthless bunch who are adept at exploiting these opportunities to earn money despite the collateral damage.

This unfolding story might be a shining example of a company’s valuation that is not only detached from its fundamentals but taking off to Mars entirely due to the speculating from retail and institutional investors alike.

But here’s a reality check to bring you down to earth.

Buying GameStop stock is insanely risky as we don’t know when this whole thing will inevitably blow up with a massive selloff.

For one, there are many institutional investors with deep pockets shorting the company

The most prominent example of this is hedge fund Melvin Capital. The firm was identified by the users of r/WallStreetBets as one of the main targets of this short squeeze.

The hedge fund was initially in trouble during the short squeeze due to its huge short bet on the compnay.

But, the hedge fund was bailed out by a US$2.75 billion investment by Citadel and Point72 Asset Management.

Also, there’s a possibility that the Reddit users on r/WallStreetBets are just throwing in money they can afford to lose.

This whole event could also be masterminded by a group of experienced and rich day traders who have helped triggered this short squeeze for their own benefit.

However, it is just as possible that many r/WallStreetBets have bought into the hype and threw in their life savings or money they cannot afford to lose into the company\s stock.

They may get greedy or be too slow to react to the price crashing when this whole situation goes south.

3. We might not be in a stock market bubble but stay away from bubble stocks

In an interview with CNBC, the Chief Investment Officer of Short Hills Capital Steve Weiss weighed in on the whole situation:

“This GameStop situation is the craziest I think I’ve ever seen. Usually, you have a short squeeze and it goes up, but this one keeps going. So this really speaks to the changing demographics of investors in the market, and what I mean by that is the people that are really true investors never heard of Reddit a few years ago. Sure, it’s been around, we know it, but for that to drive a short squeeze in a company that’s so fundamentally flawed …100 per cent last week, 50 per cent today, there’s no “there” there.

''That’s why you have to be careful. But I do not think this is a manifestation of a bubble market. I think it’s a manifestation of bubble stocks, ones you want to stay away from. You want to stay with fundamentals. But we’ll see this play out over and over again with others because now they’ve proven successful.”

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This is a reminder that the craziness surrounding the company will not affect the overall stock market too much.

Even though US stocks led by tech stocks like FAANG are at an all-time high and valuations are rather frothy.

Their stock prices keep going up.

This could be a clear sign that many large-cap stocks in the US are more resilient than we think and can survive or even thrive during this period of Covid-19 and economic uncertainty.

Overall, in my humble opinion, I would avoid the GameStop bubble stock as there’s no telling when this whole thing will inevitably blow up with a massive selloff.

But that’s just me…

As always, do your due diligence before you consider any investment at all!

This article was first published in Seedly. Disclaimer: The information that follows serves as an educational piece and is not intended to be personalised investment advice. ​Readers should always do their own due diligence and consider their financial goals before investing in any stock. The writer may have a vested interest in the company mentioned.