What in the world is going on with GameStop (GME) stock prices this week? Meteoric stock price appreciation, amidst a brewing war between retail investors and billion dollar hedge funds.
This situation has the potential to change Wall Street permanently. But that begs the question, what exactly is going on?
Investing, The Traditional Approach
One primary way that we reach financial freedom is through investing. Putting your money to work, so that you don’t have to.
To do this, you find someone who needs your money, loan it to them, and they pay you back over time. This could be buying real estate you plan to rent out, where someone needs your money to own the property, and they pay you for that privilege through rent. Alternatively, you could find a company, give them your money in return for an ownership stake, and you are entitled to a piece of the profits of that company. That is, in its simplest form, what investing in the stock market is.
Over time, people have found more creative ways to make money though. Some people decide to take a different approach. Instead of investing in future profits from a company, they decide that a company is less profitable than other people think. These people sell the current interest in that company, with the plans to buy back those shares when the company under-performs.
Short Selling, The Long and Short of It
Making a bet against a company is more like gambling than investing. But, it can be very lucrative, if your bet pays off.
Short selling is essentially making this bet, except with other peoples’ money. Instead of owning what they sell, they borrow the shares from someone who does own them, and sells those shares to the open market. The promise here is to buy back the shares that were sold, and return them to the original lender.
Introducing GameStop (GME) To The Game
One such occurrence happened recently with GameStop. A large institutional investor, Melvin Capital, made an aggressively large bet against a company called GameStop (ticker code GME). They did this by short selling, or selling shares of GME that they didn’t own, with the promise to buy those shares back at a later date.
Getting word of such a large bet against GameStop, some regular folks (retail investors) decided they’d take up Melvin Capital in the wager. Traditional investing logic was thrown out the window, as retail investors looked at the game from an economic standpoint. No longer was purchasing GME stock about price-earnings ratios. The value of the company's shares has become completely disconnected from its earnings multiple.
Knowing that Melvin Capital needs to buy those shares back, because those shares that Melvin Capital originally sold were borrowed, retail investors correctly understood that the game was now about Supply and Demand. It doesn’t matter how well GameStop does (or doesn’t) do. There is a guaranteed demand, so the only thing left to do was to constrain the supply. With limited supply, and high demand, the sellers pushed the price equilibrium (in this case the share price) much higher.
Changing the rules of investing, particularly on this GME stock, led to a rapid appreciation in share price. Meaning that while Melvin Capital sold shares at prices in the low teens, they now had to buy those same shares back at prices in the hundreds. Essentially, Melvin Capital stood to lose billions.
Changing The Rules of The Game
With billions of dollars at stake, some people will do just about anything to not lose. Those people are willing to lie, cheat, and steal.
And that’s exactly what they did.
By Wednesday, January 27th, 2021, this GME situation was out of hand. The share price was rising exponentially, and millions were getting involved. Robinhood, a trading app, was the most downloaded app in the app store, as both news and social media stirred up a feeding frenzy. A whale (Melvin Capital) was dying, and everyone wanted their pound of flesh.
Shortly after market open on Thursday, January 28th, 2021, there was a violent change to the game. The institutional investors flexed their muscles, and many brokerages including Robinhood and Interactive Brokers, placed buying restrictions on retail investors. These actions prevented normal people like you and I from participating in the investment markets.
That single act, of greed and desperation, threatens to disrupt the entire financial system as we know it.
What’s Next?
You may be wondering, “I don’t own GME, so why would this be important to me?”
By assaulting the retails investors ability to openly and fairly trade in specific investments, both moral and legal codes were violated. The class action lawsuits already opened against such trading platforms, coupled with SEC investigations, and the millions of eyeballs trained on this developing situation could certainly impact how brokers and institutional funds operate.
For anyone who has investments, whether it is just your retirement accounts, or you actively trade, legal changes in the securities industry look to be just on the horizon. Being aware, and staying in the know, will help you set yourself up for success as the world continues to change and evolve.