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David and Goliath - Short squeeze at GameStop

David and Goliath - Short squeeze at GameStop

It's reminiscent of David and Goliath. Thousands of investors of the Reddit forum WallStreetBets have forced a short squeeze at GameStop and made big players of the financial industry furious. The stock has risen from $17.25 to over $300 in just four weeks since the beginning of this year, more than a tenfold increase. What is behind the most exciting story of the new year?

GameStop

GameStop Corporation is an American retail chain for computer games and has had quite a few problems for several years. The business model has not been sustainable for a long time, as entertainment software is increasingly purchased online.

Ryan Cohen acquired a 12.9% stake in GameStop last year for $76 million and has since been pushing to transform the company into an e-commerce retailer. Ryan Cohen is the founder of Chewy.com, an online retailer of pet products that sold for $3.35 billion in 2017.

Because of the weakening business model, many hedge funds have been building short positions. But what does it mean to "short" a stock?

Short Selling - Explanation

A short sale is a sale of a security where the seller does not own the security he is selling. In this process, the short seller borrows a security, such as a stock, from a bank or other institution for a lending fee. The short seller can sell this share on the stock exchange, let's assume for 10€, which is booked into his account. If the share now falls to 5€, the short seller can buy back the share for 5€ and gives it back to the bank. His profit is then the difference between the selling price and the buying price minus the corresponding lending fee. If the lending fee is neglected, his profit would be: 10€ - 5€ = 5€.

But it can also go the other way: If the share price rises, the loss is not limited, i.e. the short seller can even make a loss that is greater than his initial stake. For example, if the share rises to 30€ and the short seller closes his position, he must buy the share for 30€ to be able to return it. The loss is therefore 10€ - 30€ = -20€.

In the case of GameStop, over 130% of the shares in float were sold short. Yes, you read correctly, there were more short positions than shares tradable. This can be caused by a borrowed share being sold back on the stock market and bought by another investor. Said stock is then held at a bank, which in turn can lend the stock on. Hedge funds Melvin Capital and Citron Research, in particular, had built up large short positions, and in total over 130% of shares outstanding were briefly sold short.

WallStreetBets vs. hedge funds

In the Reddit thread "WallStreetBets," a forum for investment millennials, the user DeepFuckingValue established his first GameStop long positions back in September 2019. More and more Reddit users took notice of GameStop and its unusually high short positions, collectively invested into GameStop, and together forced a short squeeze.

Short squeeze

To open a short position, one must deposit additional collateral (usually in the form of cash) in what is called a margin account. If the stock is sold short and then rises sharply, a "margin call" follows. In this case, the speculator must either deposit more money as collateral or is forced to close his short position. If he decides to do the latter, he buys the stock back from the market and thus creates even more demand. As a result of the increased demand, the price of the stock rises, so in turn even more short sellers have to close their position. However, if none of the GameStop stock owners want to sell their shares, and this is exactly what was called for in the Reddit forum, the short sellers have to offer ever higher prices. This leads to a vicious cycle for all short sellers, which is still ongoing.

The GameStop stock price is now completely disconnected from fundamental data and is purely a casino stock. According to Reddit users, however, the stock apparently only knows one direction: "TO THE MOON! 🚀”

Elon Musk, of course, is in on this stock space ride, and he's been generating even more attention on Twitter:

Hedge funds apparently admit defeat

Melvin Capital and Citron Research say they have closed out most of their short positions, though some still question this. Melvin Capital, meanwhile, has received a $2.75 billion financing from two other hedge funds, and Citron Research founder Andrew Left also asserted in a YouTube video that he and his firm were doing well.

The battle between financial sharks and a crowd of private investors is nearing the final round, but still doesn't seem to be completely over. Whether you have some money in GME or are watching from the sidelines, the next few days will be exciting!