While it might seem like the GameStop stock activity was like nothing we’ve ever seen before, that’s not entirely true.

For those of us who remember the early 2000s, we saw retail traders short squeezing tech stocks in a similar fashion by communicating over Yahoo message boards. In 2021, the focus was on the gaming retailer (along with Blackberry and AMC), the communication system was Reddit, and the added twist was the mobilization of larger amounts of people with access to more sophisticated tools to enact their trades.

 

When Old Concepts…

Some of the elements involved in the rise of GameStop stock have been around since the beginning of the stock market. For example:

Short Selling

Most people are familiar with making money on the “up” – as you invest and the price of the investment rises, you make a profit on the rise in price. Short selling is the opposite; it’s a way for investors to make money on the “down.” Investors find stocks that they believe are overvalued and that they believe will go down in price in the short to mid-term.

Short Squeezing

When more and more short sellers load up on a particular stock or investment, there is said to be a lot of “short interest” in the position. Investors who are savvy and bet against the short sellers can buy the underlying investment to drive up the price of the stock. This puts the investors hoping to see the price fall in an uncomfortable position. Short sellers must either unload their shares or buy more of the underlying stock to defend their “short interest.” This is called a short squeeze, where investors try to drive up the price of a “shorted stock,” leaving short sellers to hold the bag.

 

…Meet New Technology

However, some of the components are relatively new, but had a huge impact on GameStop’s rise.

Reddit

Reddit is a social media platform much like Facebook and Twitter, but it’s organized based on interest. To be more specific, “a social news platform that allows users to discuss and vote on content that other users have submitted. To help police the site and prevent spammers from bombarding readers, Reddit came up with “karma” points. Users get karma by their comments and links being up-voted by others in the community.” (Source)

Because it’s segmented by interest, there is an entire section dedicated to investing. And while other platforms like YouTube and Twitter had a hand in popularizing the purchase of GameStop stock, Reddit was where many traders found their information and were encouraged to buy in.

Robinhood

Robinhood has empowered a lot of investors to get involved in finance and investing. Tools are now available to the average investor that weren’t available in the past, such as purchasing stocks on margin and options trades.

However, while it’s great that these sophisticated investment tools are becoming more readily available, the concern is that everyday investors don’t understand the power/ implications of them. While these same tools let average investors trade like hedge funds, many average investors aren’t sophisticated enough to understand the huge loss potential from buying on margin or what happens when options trading goes wrong.

As a metaphor, imagine your dream was to drive in NASCAR. In the past, access to such sophisticated cars, engines, and equipment wasn’t feasible. However, now you can drive Ferraris, Bugattis, and whatever other car you’d like. The issue is, while some average drivers can handle these sophisticated cars many would most likely crash the cars – causing significant injuries to themselves and those around them.

 

Here’s What Happened

Short selling in general is relatively synonymous with hedge funds. In fact, most hedge funds manage their portfolios in a short/long fashion. Meaning part of their portfolio is trying to make money on the up while the other part is trying to make money on the down.

In this case, Reddit noticed that hedge funds had a substantial “short interest” in GameStop stock and rallied its user base to “short squeeze” the stock. This would accomplish two objectives: make the Reddit traders money, but more importantly, stick it to the “man” (hedge funds).

 

What’s Next?

Now that we’ve taken a look at how and why GameStop had a meteoric rise at the beginning of 2021, let’s talk about the issues that arose from this activity. In the next blog we’ll discuss:

• Why Robinhood stopped trading GameStop stock and whether or not we agree with that action.
• What investors should be cautious about when it comes to this type of investing.
• The importance of understanding the difference between the type of day trading many were participating in and long-term investing strategies.
• Why parents should discuss responsible financial planning practices with their young adult kids.

 

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