The GameStop Short Squeeze

How a reddit forum cost Wall Street hedge funds billions of dollars

By: Gabe Rodriguez Morrison

In June of 2019 a r/wallstreetbets user by the name of u/RoaringKitty made a post titled “GameStop YOLO”. In this post he outlines the bull case for GameStop (NYSE:GME), implying that the video game retailer is undervalued at $5 a share. He also discloses his $50,000 position in call options expiring January 2021, betting that the stock would increase by expiration. His $50,000 call options are now worth about $25 million.

In August of 2019 Micheal Burry, famous for shorting the housing market in 2008, discloses a 3% position in GameStop at $4 per share. Micheal Burry and u/RoaringKitty both saw deep value in the company despite the fact that it was heavily shorted. Melvin Capital and Citron Research among other hedge funds were short-selling shares of GameStop, betting that the stock would decrease in value. These hedge funds took the risk of shorting GameStop because they believed that the trend of e-commerce and digital gaming would surely disrupt and displace the retailer just how Netflix displaced BlockBuster.

In August of 2020 (a year later), Ryan Cohen, Founder of Chewy (NYSE:CHWY), takes a 10% position in GameStop at $5 per share and later brings his expertise in e-commerce in order to help turn things around for the retailer suffering amid the pandemic.

In September of 2020, another r/wallstreetbets user notes that GameStop has 120% short interest, meaning that more shares in the float (available for trading) are being shorted. When a short seller sells their borrowed shares, another short seller borrows those shares to short-sell them and the cycle continues. This Reddit user also highlights more fundamental value in GameStop, implying that it is still undervalued at $10 per share. He cites new gaming consoles coming out, gaming consoles still using hardware discs and GameStop loyalty programs having 55 million customers. Furthermore, if the stock were to increase for these reasons, short-sellers would have to cover their positions by buying back the shares they short-sold, continuing to drive up the stock price. The user predicts that the convergence of all these factors would lead to the big short squeeze of 2021. As the self proclaimed degenerates of r/wallstreetbets slowly catch on to this, shares of GameStop get bought up and the price slowly increases over the next few months to about $15 per share.

In early January 2021, Ryan Cohen is officially added to the board of directors along with the former CFO and COO of Chewy. They bring their expertise in e-commerce and the stock goes up to $20 per share on this news. This news causes Reddit users to become extremely bullish on the stock, citing new and improved management and proclaiming Ryan Cohen as their saviour. For the next month, discussion about GameStop on Reddit, Twitter, StockTwits and Discord explodes, leading to a 120% surge in stock price with shares trading around $40. Institutional investors double down on their short position with short interest increasing to 140%. This causes retail investors to triple down on their position causing the stock price to surge 700% to an all time high of $350. As the story goes viral, millions of new users join r/wallstreetbets and begin encouraging each other to “hold the line” to squeeze out the short sellers on Wall Street. What started as a trade based on fundamentals turned into a momentum trade which then turned into a revolt against the establishment.

The narrative became retail investors taking on institutional investors that have historically manipulated the market in their favour. This presented an opportunity for “Main Street” to outsmart Wall Street in an unprecedented power shift in the stock market. With the advent of the internet and mobile trading, hedge funds have less of an edge over retail investors than ever before. The power of the internet enabled retail investors to collectively go against the establishment and beat Wall Street at their own game. Although the trade achieved poetic justice, hedge funds eventually went on both sides of the trade, chasing the momentum driven by retail investors. The Reddit forum did cost some hedge fund billions of dollars but simultaneously made quant funds and momentum traders on Wall Street a lot richer.

The GameStop short squeeze is a reminder that the stock market is not necessarily the study of business fundamentals. It's the study of how people take risk and behave with their money, and sometimes those behaviours can be very unpredictable.