GameStop and the Short Squeeze

Keep in mind the following information is General Advice and is obviously not personalised for your unique needs, objectives or financial situation. Please get in touch with your advisor if you have any queries about how this may affect you.

The recent GameStop fiasco has garnered attention and curiosity around the globe in the last few weeks. The investment strategy of short selling has also come to light as people everywhere are perplexed by the turn of events that led to such substantial losses for a hedge fund.

So, what does it all mean?

What Has Happened?

GameStop, a US-based video game retailer, has seen its share price rise from $20 in late December to a peak of nearly $500 by late January. Several large institutions had been positioned to benefit from a fall in the share price via a strategy known as “short selling”, and the rapid appreciation in the stock price quickly caused large losses for these firms. The extreme volatility in the share price soon began to cause issues with US share clearinghouses. Several large brokerage firms, including Robinhood, were forced to restrict trading on GameStop and other highly volatile stocks.

What is Short Selling?

Short selling, or Shorting, is a strategy designed to produce a profit from the expected fall in the price of a company’s stock. Should a company be identified as strongly overvalued, an investor can short that company so that the investor earns a profit as the price falls back to fair value.

A successful short strategy is implemented by borrowing a stock from another investor and selling it immediately at current market value, before repurchasing the stock back a later date for a lower amount.

Why GameStop?

Given the rise of e-commerce and cloud-based gaming, GameStop, as a brick-and-mortar retailer, had been experiencing a decline for a number of years. Given the weak outlook for the company, many large institutions had chosen to short the stock, hoping to profit from further falls in the share price. This collective positioning led GameStop to eventually became the most shorted stock in the market.

By late 2020, the high level of short selling of GameStop generated interest across internet discussion forum Reddit. Users on Reddit realised that if they collectively purchased millions of shares of GameStop, they could drive the share price sharply higher, leading to losses for the institutions who had shorted GameStop. As the institutions began incurring losses on their short trade, they may have chosen to close out their position by purchasing GameStop shares (to offset the shares they had sold at the beginning of their short strategy). This forced buying would only drive the share price higher, leading to additional losses for remaining short-sellers and likely forcing them towards closing out their own positions by buying more stock. This vicious cycle is known as a “short squeeze” and can quickly generate large gains for stockholders (i.e., the users from Reddit) while heavy losses for those shorting the stock (i.e., hedge funds).

The GameStop trade was collectively implemented by retail investors in late 2020 and throughout January, forcing the “short squeeze” the investors targeted. This produced many winners and losers over a short timeframe. The Reddit users who were early to the trade became overnight millionaires, while those that joined in mid to late January achieved varying results (the GameStop share price is down over 50% from its peak). Several hedge funds, including high profile Melvin Capital, suffered falls of over 30% in January alone, due to concentrated bets on a falling share price that failed to materialise.

Should Investors Short Companies?

Although short selling attracts its share of unscrupulous operators, the core strategy enables the markets to function smoothly by increasing liquidity, providing some defense against financial fraud by exposing companies that have fraudulently attempted to inflate their performances. Short selling also serves as a restraining influence on investors’ over-exuberance. Excessive optimism often drives stocks up to lofty levels, especially at market peaks (e.g., technology stocks in the late 1990s). Short selling acts as a reality check that prevents stocks from being bid up to ridiculous heights during such times. Given fund managers’ focus on finding companies that don’t have underlying earnings that match their high stock price, short-sellers have helped uncover many examples of corporate fraud, including high-profile companies such as Enron.

Does Morrows have Exposure to Short Selling Strategies?

Some fund managers used by Morrows employ short strategies, primarily as a method to cushion investors from a severe fall in markets. The fund manager would expect to generate some profit from the short strategy during a market correction, which serves to help offset losses elsewhere in their portfolio. Strict risk management processes are in place to ensure the fund manager is not overly exposed to any individual security.  To date, no fund managers that we invest in have had any exposure to the high-profile trading of GameStop and other similar companies in the US. We continue to monitor the ongoing volatility in the US and the portfolio positioning of our fund managers, on a daily basis, and we remain comfortable retaining our existing strategies.

The GameStop story is a compelling curiosity of how individuals can utilise market forces and strategies to achieve their objective. If you have any questions about the GameStop case, short selling or any of the above matters, don’t hesitate to get in touch with your Morrows Private Wealth advisor.