What happened with GameStop’s short squeeze in 2021?
I wanted to post this article sooner, but I decided to wait until the frenzy died down. While I can’t say definitively that the GameStop (GME) saga is behind us, I think enough time has passed now to take a look at what happened.
In the first two months of 2021, the investing world bore witness to an incredible spectacle - an epic battle between retail investors and short sellers that spilled outside of financial news and captivated the attention of the world. Fortunes were made and lost within the span of days. Accusations of rampant market manipulation flew from every side. People who had no knowledge of investing were gossiping about it at work. People bought GameStop with next week’s rent money. The short squeeze of GME might be over, but the fallout from this saga surely isn’t, and its ripple effects might be felt for years.
Image from iOS stocks app. GME 1 month price history as of February 5, 2021
For me, the fascination with GameStop goes beyond just retail investors versus short sellers. The real implication is whether the efficient market hypothesis is correct, and how companies are valued in the first place. GameStop clearly showed that, at least in the short term, markets are not efficient. Stock prices can be driven by human behavior and other external factors to the point where they are completely divorced from the fundamental metrics of a company. This is something that author and economist Burton Malkiel referred to as the “castles in the sky” method of valuation - if someone is willing to pay $1,000 for a stock that is “worth” only $10, then that stock is in fact worth $1,000, regardless of what anyone else thinks.
GameStop didn’t just spike almost 500% in one week for no reason, however. To understand what happened with GameStop, we need to understand, among other things, short selling, leverage, margin calls, and short squeezes.
What is short selling?
Traditional investing, where a stock is bought and held, is called a “long” position. Whether you actually hold it for a long time or not is irrelevant. What’s important is that you bought the stock and you own it. The vast majority of investors hold long positions in stocks, ETFs, or mutual funds. I am long and so are you. There are two main ways to make money in a long position - either the asset pays dividends/interest, or the asset appreciates in value and can be sold for more money at a later date, or both. Long positions can be made either with or without leverage (investing with borrowed money).
The opposite of a long position is a “short” position. A short position is one of the few ways to make money on an asset that you believe will decrease in value in the future. For example, if you believe a company is failing and will soon be bankrupt, you can short its stock. To short a stock means borrowing shares of a stock that you don’t currently own from someone (usually your broker) and selling them at current market price. If you are correct and the stock price declines in the future, you can buy back the shares at a lower price in the future to repay your broker. By definition, short selling must involve use of leverage, because you are borrowing and selling something you don’t own, with the intention of paying it back later.
To have a long position means you have a generally positive (bullish) outlook on that position, and to short it means you have a negative (bearish) outlook on it. But long positions and short positions don’t just have different philosophies. They have very different risk and reward profiles. In a long position, your maximum loss (downside) is the amount you invested, but your maximum profit (upside) is theoretically unlimited, because there is no limit on how high a stock’s price can go. For example, if you bought XYZ for $100, your maximum loss would be $100 if XYZ went bankrupt and went to 0. But if XYZ went to $200 or $500, your profit would be $100 or $400, respectively. However, in a short position, the risk/reward profile is flipped. Your maximum profit is the amount you initially received when you sold the borrowed stock. Your maximum loss, however, is unlimited.
This is immediately intuitive to some people, but not others, so the following charts and examples might help. Assume that you believe XYZ is a failing company that will go bankrupt soon. Its stock currently trades at $100. You must short the stock if you want to profit on its future decline. Therefore, you borrow a share of the stock to sell today for $100. At some point in the future, if the company does poorly and its stock declines to $50, you can buy it back on the open market for $50 to repay the share you borrowed. Your profit is $50 in this scenario. Your maximum profit on this short position is $100 if the stock goes to $0. However, if you are wrong and the price of the stock increases in the future, you would suffer a loss when your broker asked for the borrowed share back. If XYZ went to $200 or $500, your loss would be $100 or $400, respectively, if you were forced to close out your short position. Again, there is no limit on how high a stock’s price can go, but in the case of short selling, it’s your downside that’s unlimited.
Under normal circumstances, if you are convinced about the long-term direction of a stock’s movement, temporary changes in price opposite of that direction isn’t of much concern . However, short sellers are susceptible to being forced to close out short positions prematurely - in other words, you don’t have enough time to wait, even if your analysis of the company’s decline in the future ends up being correct. This occurs due to both margin interest as well as margin calls.
What is a margin call?
Remember that short selling requires leverage by definition. You are borrowing from your broker, or using “margin”, which leaves you with a margin debt. Any use of margin carries an interest rate, which is the rate that the brokerage charges for lending you money. The balance of this position, based on the current market price of the stock if you had to buy it back to pay your broker, is reflected in your account. If the short position moves against you, this margin debt can grow beyond your initial borrowed amount. And because the position has unlimited downside, there is no ceiling to how large your margin debt can get. Because nobody has unlimited liquidity or can pay back unlimited debt, most brokerages have very strict limits on how much margin debt you are allowed to carry - usually no more than 25% of your total account assets. This is to ensure that the brokerage can protect itself and actually collect on its debt. Therefore, if the stock’s price keeps going up and your margin debt increases beyond your margin limit, you will get a “margin call”. This means that you either have to deposit more money into your account, or, if you have no more money, you must close out your short position before you suffer any further losses. Furthermore, if you fail to provide the necessary capital, your broker will automatically close your short position and liquidate your long assets to pay off the debt.
Getting margin called is the bane of any short seller, because it forces them to “realize” the loss. It means that even if the short seller’s analysis was correct and the price of the company’s stock declines in the long run, the short seller might not have enough time or enough liquidity to maintain the short position. Whereas an investor can hold a non-margined long position forever, a short position is not afforded this luxury. This is one of the main reasons that short selling is typically not employed by individual investors, who have limited assets and liquidity, but is more often done by hedge funds. In fact, short selling is a common strategy employed by hedge funds, not only for profit, but also as a “hedge” against market downturns. Hedging strategies give hedge funds their name and distinguish hedge funds from traditional mutual funds. But even the largest of hedge funds do not have unlimited liquidity and cannot suffer theoretically unlimited losses either. Therefore, sometimes a heavily shorted stock can undergo a phenomenon known as a "short squeeze”.
What is a short squeeze?
If there are many short sellers of a stock, whether individual or institutional, then rising prices can trigger an avalanche of margin calls, almost like a bank run. Here’s what happens: as the stock price goes up, short positions start to post losses. If the losses are not too large, then the short seller can “wait out” the stock price increase (if its temporary), and still end up profitable in the end. If the stock price increases too much, however, the less risk-averse short sellers will exit, and the less well-capitalized short sellers will get margin called. As they exit, whether by choice or by force, they must close out their short position by buying the shares at current market value to repay their broker. This forced purchasing of shares increases demand for the stock, which causes price to increase even further, causing additional short sellers to exit or get margin called. This process is accelerated if the stock’s supply for purchase is limited (for example, a small company with not very many shares outstanding, or people who currently own shares are unwilling to sell it to the short sellers). The stock’s upward price movement forces more and more short sellers to close their positions, creating a vicious cycle. This can cause the price of a stock to skyrocket to unthinkable levels within days. This is a short squeeze.
During a short squeeze, the stock’s price is completely divorced from the fundamentals of the company, and is instead subject only to artificial supply and demand. Once enough short sellers have exited their short positions, this artificial surge in demand for the stock (from short sellers needing to buy shares to close their positions) drops off, and the stock’s price usually plummets as quickly as it surged. Eventually, the stock price will return back to a value that actually matches the fundamentals of the company.
In 2008, Volkswagen group experienced a spectacular short squeeze that briefly made the company the largest in the world by market capitalization. Volkswagen did have a significant amount of short interest at the time, which essentially indicates how many shares of its stock are being shorted. Porsche subsequently announced that it had purchased a significant stake in Volkswagen in a takeover attempt, which served as the catalyst for the short squeeze.
Unlike the GME drama, this event was not well known to the general public at the time, as Volkswagen is traded on a German stock exchange and this squeeze occurred during the height of the global financial crisis. But it perfectly illustrated the elements of a short squeeze: a high number of shares sold short (and thus would need to be bought and repaid), relatively limited supply of shares for trading (Porsche purchased a large stake with no intention of selling), and a catalyst to drive up the share price.
What happened with GameStop?
To put it simply, GameStop experienced a short squeeze similar to Volkswagen. A number of people on the internet, most notably on the wallstreetbets subreddit, found that GameStop was the most shorted stock on the US market, and that most of this short interest was held by several hedge funds. High short interest sets the foundation for a potential short squeeze. On January 11, Ryan Cohen, a successful entrepreneur, activist investor, and founder of e-commerce business Chewy.com, built up a minority stake in GameStop and acquired 3 board seats, with the intention of turning GameStop’s failing retail business around. This limited the supply of GME shares as well as served as the price catalyst. Retail investors then began buying as many shares of GameStop as possible with the intention of holding onto the shares, making these shares unavailable for short sellers to buy back, and hype for GME reached a fever pitch. More and more people piled into GME while pledging to each other that they would never sell and would hold GME, no matter what, with “diamond hands” (on wallstreetbets, this is the opposite of “paper hands”; someone who doesn’t have the strength to hold a position and bails at the first opportunity). And as it turns out, this indeed had the desired effect. Over the next 10 days or so, GME shares steady rose in price, going from $19.94 on January 11 to $65.01 by the end of the week on January 22. This closing price on January 22 was higher than what GME had ever been at any time in the company’s history (its previous peak was $63 in 2007). Sure enough, when markets opened again on January 25 and over the rest of the week, short sellers began exiting their short positions. The short squeeze was on and the price of GME exploded.
Ultimately, GME’s price closed at a high of $347.51 on January 27, with an intra-day high of $483 on January 28. But the short squeeze ended just as rapidly as it started. This was caused by two main reasons. First, many short sellers did exit their positions during the squeeze, suffering significant losses. Melvin Capital, a hedge fund that held significant short interest in GME, reported losses of 53% of their approximately $12 billion in assets. Once enough short sellers exit, a short squeeze naturally ends. Second, the unprecedented volatility caused many brokers, including Robinhood, to restrict trading of some stocks, including GameStop. This was an extremely controversial decision, but the result was that many retail investors wanting to “keep the squeeze going” by buying more GME were unable to. By Tuesday, February 2, short interest in GME had plummeted, indicating that most short sellers had closed their positions. The squeeze was over and GME fell back to earth.
When a short squeeze ends, the stock price drops as rapidly as it once rose. This is because the artificial demand for the stock is gone once the short sellers exit. Instead, investors are left holding shares of GME at $400, when the stock is really only worth about $10 or $20. Nobody wants to be the last one left holding an empty bag. A massive sell-off ensues as people desperately rush for the nearest exit. Suddenly, supply of the shares far exceeds demand.
The difficulty with trying to profit from a short squeeze is that it is almost impossible to time correctly. As the squeeze happens, nobody really knows, or can predict, how high the price will get, when the squeeze is going to end, or if the squeeze has even started yet. For example, I bought a few shares of GME at $38 on January 14, and when GME hit $65 on January 22, I thought the squeeze had already happened. A friend of mine bought some shares at $100, but missed the opportunity to sell at $300 or more, and panic sold his shares when they fell back to around $120. Had he waited any longer, he might have suffered a large loss. And even today, there are stubborn investors still holding on to their GME, believing that the squeeze has not yet fully played out.
Many investors who were swept up in the hype and didn’t fully understand the situation bought into GME at $300 or even $400, and were blindsided by the speed and magnitude of the subsequent decline. Playing with GME was playing with fire, and many got burned.
GameStop was not the only company that experienced a short squeeze during this time. A few other companies with high short interest, notably Nokia (NOK), BlackBerry (BB), AMC Entertainment (AMC) and KOSS (KOSS) also experienced some degree of squeeze, although none had as much short interest as GameStop and none of these squeezes were nearly as spectacular.
Images from iOS stocks app
Note that all of these squeezes occurred essentially during the same time period: started late January 2021, peaked around January 27, 2021, and fell off a cliff by the first week of February 2021.
Final thoughts
GameStop wasn’t the first short squeeze and likely won’t be the last. However, the degree to which this short squeeze played out in the public consciousness is unprecedented. Any legislative, regulatory, or legal fallout from this saga remains to be seen. If nothing else, however, GameStop demonstrated the power of retail investors and exposed the risks of excessive short selling and leverage. I’m sure that many hedge funds which engage in short selling will be looking at the size of their short bets and the adequacy of their risk management strategies going forward.
Ironically, the company itself is basically unchanged. Its stock was the battlefield where short sellers and retail investors waged war, but the fundamentals of the company remain the same. Whether it can turn around its struggling retail business remains to be seen. Alongside speculative bubbles, short squeezes like GME provide one of the best examples of how a company’s stock price can become completely divorced from the company’s fundamental valuation. At the same time, however, it is also a clear demonstration that the market does not tolerate price distortions for long, and that fundamentals will prevail sooner or later.
The GameStop saga has also been described as a kind of financial populism, where retail investors took on huge hedge funds and won. The truth is, however, that institutional investors were also on both sides of this battle, and while some hedge funds did suffer huge losses, many others funds experienced large gains as well. And many retail investors who bought into GME during the crazed hype and run-up without fully understanding the situation were caught unaware by the rapid end of the squeeze and suffered tremendous losses as well. No money was made; money only exchanged hands during this saga. Any investor’s profits came from another investor’s losses. The stock market overall is a rising tide, but trading, as always, remains a zero-sum game.
Happy investing!
