The Investment Scientist

The GameStop Story

Posted on: January 31, 2021

Before I tell the story, let’s get a few concepts clear.

Short Sell (short) means selling shares you don’t actually own. Instead, you borrow them from the brokerage to sell, but you have to buy them back at some point in the future, hopefully at a lower price, to pay back the brokerage shares you owe. To guarantee that you have the money to buy back shares you owe at all times, the brokerage requires you to have a maintenance margin of 130% of the value of the shorted shares to keep the position open. If you fall under the margin requirement, you will get a margin call to post additional money. Should you fail that, the brokerage will close your positions. This is done by buying shorted shares in the market using your money in the margin account. This forced action can cause a short squeeze. I will give you the definition with an actual example of GameStop (GME).

Just two weeks ago, GME was being traded at around $20. Some big hedge funds like Melvin Capital (Melvin), thought it should be worth only $5, so they began to short the stock. At one point, the short interest ratio, the number of shorted shares relative to the number of outstanding shares, was 140%. Since GME has about 70 million shares outstanding, Melvin shorted nearly 100 million shares of GME. Apparently, a portion of those shares was borrowed and sold twice.

Now if GME had indeed gone down to $5, Melvin would have made $15*100 million shares = $1.5 billion profit. But since GME went up to $420 at one point, Melvin suffered a loss of $400*100 million shares = $40 billion at one point!

But how did GME go from $20 to $420 in less than two weeks? It’s called a short squeeze. A horde of retail investors, gathering around a Reddit discussion forum called Wall Street Bets, coordinated the purchases of GME and refused to sell. Their collective action drove the GME price up. Let’s say initially the price went up only from $20 to $30. At $20, the margin requirement for Melvin was $20*130%*100 million shares = $2.6 billion. At $30, the margin requirement was $30*130%*100 million shares = $3.9 billion. Melvin needed to post an additional margin of $1.3 billion.  Since it happened so quickly,  Melvin had no time to raise that much money on such short notice, so the brokerage had to buy about 35 million shares of GME to pay back the lent share to keep Melvin within margin. When these purchase orders went out to the market, and nobody (coordinated in Wall Street Bets) was selling, it drove the price up to the roof! Just like this, a relatively small coordinated push created a snowball effect. 

While this was painful enough for the hedge funds, it took none other than Elon Musk to turn the screw! He posted on twitter one word “Gamestonk!” with a link to the Wall Street Bets site, essentially sending his 40 million twitter followers to join the battle. When they saw prices were rising fast, they snapped up whatever few shares left in the market, making it even more impossible for Melvin to cover its short position. This is an epic short squeeze!

That was essentially what happened, though I was very loose with numbers while telling the story. The GameStop story does not stop here. There are many interesting subjects to write about, like (in no particular order):

  1. The reinforcement and the standoff. (The empire strike back!)
  2. Gamification, socialization, and virtualization of stock trading.
  3. Why did the broader market fall?
  4. The GME buying ban at Robinhood and the shutdown of Wall Street Bets and Discord. 
  5. Should regulators step in? Whom should they regulate?
  6. The systemic risk of big hedge funds going under.
  7. The societal risk of tens of millions of small investors losing everything.
  8. What’s the implication for the stock market going forward?

Feel free to share with me your thoughts, or tell me what you’d like me to write about next.

Schedule a 2nd opinion financial review, buy my wealth mgmt book on Amazon.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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