Last Updated on 28 January 2021 by Dan
Hello everyone. Something which has caught news headlines over the last week are the impact that smaller traders have had on the share price of Gamestop, a bricks and mortar retail shop that sells computer games and consoles in the US.
In some parts of the media the case has been framed as a “Wall Street vs. Main Street” case where the small guy has won. (The BBC article if you’re looking for more background is here.)
I’m not convinced by that narrative but this is a really interesting example of something unusual happening in the market, and I thought I’d write my thoughts down on it and explain some of the principles behind what’s going on.
What has happened with Gamestop?
Gamestop is a company that has faced financial trouble, being a slightly more traditional business model with bricks and mortar stores in a world affected by both the pandemic and a general switch to online shopping. The company has consistently been in a defensive position, closing stores and posting heavy losses.
On Wall Street, two hedge funds in particular engaged in the short selling of Gamestop’s shares. I’ll explain more what short selling is below, but the short version is that it’s taking a position against the share price (or in other words you reach a conclusion Gamestop’s share price will go down). When you do this you’re described as having a “short position” or “being short”.
On Reddit (a social networking site) there are groups dedicated to discussing investments and stock market speculation. One of these groups (there’s a few, but notably the board r/WallStreetBets) noticed the “short” position of the hedge funds on Gamestop and started to encourage people to buy Gamestop’s shares instead. It build momentum and the price of the shares began to rocket.
Motivations were mixed – some people purported to be buying to take advantage of the share price increase, and some people wanted to “stick it to Wall Street”, and I’ll move on to explaining how that happens via discussing short selling.
What is short selling?
You obviously can’t sell a stock that you don’t own – so if you’re taking a short position you instead borrow the stocks from someone else who does own the stock with a promise to repay them with the same amount of stocks plus compensation for the borrow.
Assuming you’re correct in your belief that the price does drop, you’ve sold high and can re-buy low when returning the stock, which is how you make a profit. A lot of hedge funds generally engage in this activity to some degree.
To make sure your position is always viable, you have some form of margining. This is designed to ensure that where one counterparty in the lending deal is loss making and one is profitable the gap of what’s owed never gets too big you settle the balance as it goes, rather than at the end of the deal. The idea is to limit the credit risk that could occur where one party owes the other a huge amount they can’t afford.
In the case of Gamestop, as the hedge funds have a short position and the stock price has gone up they’re being called for margin, and the extent of the price movement is such that it’s very expensive, with them having to scramble to find money to meet the margin requirement and maintain their positon. Where this happens, it’s known as a short squeeze.
Short selling places additional pressure of companies and for obvious reasons owners for the company don’t like it as it dilutes the value. This has caused some ethical debate on if short selling should be allowed, with the other side of the debate being that it can improve market liquidity and helps find true price value formation.
Why is the Gamestop and Reddit investing trend not a good thing for the market?
It might be seen as a good bit of trolling to the market and the hedge funds, but there’s a number of reasons I actively don’t see this as a good thing, and have disliked the way the media has covered this:
Nothing has changed for Gamestop
Well that’s not entirely true – it’s technically a much more valuable company than it was a couple of days ago. However it’s all entirely artificial, and the same problems still exist in the businesses’ ability to survive in this commercial environment and ability to return to profit.
Which means the price has become divorced from reality, and all about momentum. And when a stock becomes about momentum rather than fundamentals, the price moves very quickly indeed. Which means…..
Investors will get burned by Gamestop
It’s a bit like a pyramid scheme – those who started off at the beginning of this will probably do rather well. However if the share price comes back (and it nearly always does with momentum trades) there are going to be some people that get badly burned by this.
I hate these situations because investing done well are carefully can be so positive to your financial wellbeing – it’s what this site is all about. When people lose in these types of scenarios, they often walk away thinking investing is not for them, or it’s so fundamentally risky that it shouldn’t be touched, when they’ve just waded into the deep end of the market…..
It’s essentially gambling
One of the arguments used by those behind this movement is that Wall Street is essentially a casino that lost big in 2008.
Banking does have a culprit role in helping drive the 2008 crash, but let’s be clear that what truly competent professional investors do is largely far away from this, with extensive research and modelling against the underlying cash flows and positions of the firms they are investing in.
If you do this kind of fundamental analysis of Gamestop, you’ll likely end up concluding that the logical position was the same as the hedge funds, not to buy it as an investment.
Any investment is going to involved taking risk – but it’s a measured and researched one for professionals, not investing in a company that doesn’t make sense to put money in based on a message board.
It’s completely contrary to market rules
Talking up a stock to get people to buy it before selling it off once you’ve got them to do so is completely contrary to market rules, and known as a pump and dump scheme. (For those who’ve seen Wolf of Wall Street, it’s the same principle that Jordon Belfort’s empire was run on).
Any professional firm would be rightfully investigated and likely be facing sanctions for what’s happening on Reddit, and just because it’s retail investors doing it doesn’t mean it’s a good thing from an ethical perspective. These are the very rules that are designed in part to protect retail investors, not screw them over.
The counterpoint that’s been made here is often some variety of that “the game is usually rigged in Wall Street’s favour”.
Again, this is wildly simplistic good v. bad thinking – Wall Street hasn’t done itself any favours with misconduct scandals – but I’ll point out that the people who were the examples there are in jail or faced heavy industry censure, and were used as the example to others if you don’t follow market conduct rules.
By engaging in this manipulation those driving message board investing are part of the problem, not the solution.
Gamestop won’t actually change anything
And finally – at the end of the day this will be an annoyance to a couple of hedge funds. Gamestop is still a company that can’t justify the valuation. People will want their money out. The market will fall back into place.
Remember the golden rules of investing:
My goodness, if we preach one thing on this site it’s our golden investment rules:
- Invest for the long term (Here’s why investing that way works)
- Invest understanding what you’re investing in. (Here’s some basic products as a starting point)
- Invest knowing what level of risk you’re taking. (Here’s how to assess your attitude to risk)
The above action is meeting none of these!
It’s a complex scenario, and if you have any questions or comments on what’s been happening please do let us know in the comments below!