GameStop Corp (NYSE:GME) is a brick-and-mortar retailer of video games which was struggling during 2021. Against its stock, several GameStop hedge funds placed massive shorts. At one moment a group of small retail investors from Reddit identified its stock and started buying it in large amounts. This drove the price of the company which triggered a short squeeze.
Hedge funds with short bets against the company were forced to buy stocks at much higher prices, just to cover their positions. This resulted in eight major hedge funds sustaining major losses. Amongst them were Melvil Capital, Light Street Capital, White Square Capital, and Citron Capital.
GameStop saga was a major hit on the financial market, pointing out their vulnerability when facing a sudden brake in the pattern. Hedge funds reevaluated their short positions, while retail investors showed their influence. The SEC conducted a wide investigation while calls for greater transparency regarding short positions were heard.
All in all this scandal was a wake-up call for the whole investing world. It showed how small investors, with the help of social media, can make a dent even in the biggest hedge fund operations.
Key Takeaways
- GameStop was one of the most shorted companies in the market. Gamestop’s stock price reflected their outdated business model, which resulted in Wall Street giants taking a bullish perspective on the stock.
- Several hedge funds bet that the bullish outlook will push the stock value further down. Indeed, the stock price reflected the company’s low performance, but from this case, it is seen that everything can happen on the stock market.
- A group of Reddit-organized investors believed that the stock’s bullish rally could push the stock price up. This would also force hedge funds to buy back stocks at a much higher market value.
- The stock rally caused the stock price to move from $20 at the beginning of January 2021 to $483 on January 28th.
- Trading App Robinhood stopped allowing users to sell stocks in the midst of the stock rally.
- This stock rally caused a storm in the hedge fund industry, resulting in major losses for several funds. After the dust had settled, SEC implemented new rules regarding short selling in an attempt to lower the chance for a similar situation to repeat in the future.
GameStop Background
GameStop is a video game company that has a long history dating to 1984. Then it was called Babbage's and their market reach was much more modest. In the next fifteen years, the company went through several mergers and rebrandings, finally becoming GameStop in the process in 1999. By that time, GameStop was the most influential player in the video game retail sector.
The company based its operations on selling new and used games and game consoles. What set them apart from the competition was the used games sector, which other retailers didn't include in their business model.
However, the gaming industry shifted with the rise of digital purchases and online gaming platforms at the beginning of the 2010s. GameStop was facing fierce competition. Steam, Xbox Live, and PlayStation Network were just a few players that took a significant part of their market share.
GameStop's business dynamics didn't leave them much room for innovation. GameStop's stock value went from $30 in 2016 to below $5 in 2019. The company faced a decline in revenue. They were forced to close the doors of many stores, which put them in a vulnerable position.
The firm did try to implement some innovations and regain a part of its old market share. They hired new executives and added gaming merchandise and collectibles to their list of operations. These efforts didn't bring expected results as stock prices hit rock bottom.
Shorting As A Hedge Fund Strategy
One of the hedge fund investment strategies, also known from the movie The Big Short, is short selling. If conducted properly it can be one of the top wealth-building investment strategies. Essentially, hedge funds bet that the specific share will lose its value. In some cases, hedge funds use options contracts with an agreed upon strike price to minimize risk in their short selling strategies.
They borrow shares from brokers and sell them at a current price. If their prediction plays out and the stock market pushes the stock value down, then hedge funds buy stocks at that lower price and return them to the lender. That way they earn the difference between the price they got when they first sold them, and the asking price when they returned them to the lender.
Short selling is often seen as a controversial strategy used by a wide range of retail investors with a margin account and institutional investors. While mutual funds, pension funds, ETFs, and endowments can use shorting, hedge funds became notorious for the sheer impact they made with it.
GameStop Short Squeeze
The bleak situation of the firm attracted hedge funds to bet against GameStop stock. GameStop had one of the highest short interests in the whole market. Over 100% of their shares were being borrowed and sold short. This meant that the company had more shorted stocks out there than the amount of shares they had.
This bullish outlook pushed retail investors from Reddit's group r/WallStreetBets to test the financial community. They used social media to share information and plan activities. Retail traders made a joint push to buy massive amounts of stocks at the same time and hit Wall Street giants.
Reddit investors saw an opportunity to put pressure on large institutional investors including big hedge fund players. Smaller investors knew that if enough pressure was applied, they would cause a stock rally. These events would subsequently push hedge funds to cover their short positions which would drive the stock price even higher.
One of the main motivators behind Reddit investors was the opportunity to hit Wall Street Hedge funds. These investors perceived some hedge fund strategies as market manipulation and this was a way to use the power of the community to hurt big players. Also, they saw the market favoring institutional investors, and this was their ticket into the game.
This joint action reflected on the stock market and the value of GameStop shares. It pushed it from under $20 at the beginning of January to $483 on January 28.
Hedge Funds Involved
Eight Wall Street hedge funds were particularly hit by GameStop. Hedge fund manager Michael Burry, known for his significant investments in GameStop, also faced substantial losses. Most of them ended up selling stocks as quickly as possible, but the amount of lost money betting against GameStop Stock took its toll.
Melvin Capital is one of the major hedge funds affected by a short squeeze. During the first three months of 2021, they lost over 49% of their investments. Due to these developments, Citadel and Point72 provided them with a $3 billion bailout plan.
Light Street Capital managed by Glen Kacher was also hit hard. The fund reported double-digit percentage losses during January. In the first quarter, the fund ended with 20% in the red.
White Square Capital didn’t find any other options after it was obliterated by the short squeeze, so they had to close their main fund. At the peak of its short position, the fund held over $440 million in assets.
Citron Capital lost 100% of its capital during the short squeeze. The founder of the company, Andrew Left three years later was charged with fraud being accused of earning $16 million through market manipulation.
D1 Capital Partners was down 20% during January, and they exited from the GameStop shares by January 27. Nonetheless, the damage was already done. D1 Capital was at the same time short selling GameStop Stock and AMC stock which was also heavily short squeezed.
Maplelane Capital was also one of the large hedge funds pitted against GameStop stock and was heavily affected by GameStop’s short squeeze. It lost 45% during January, ending the quarter with a loss of 39.5%.
Candlestick Capital founded by Jack Woodruff was in the low to mid-teen in loss percentage as a result of the actions of Reddit traders.
Some of these asset management companies were better prepared for the jump in GameStop’s stock price and managed to quickly get back on their feet. Others had their operations thwarted for a prolonged period.
The Impact Of Retail Investors And Social Media
Without the connection that social media provided to these retail investors, GameStop's short squeeze couldn't happen. Platforms like Reddit formed groups of traders with similar stances towards large hedge funds.
Through these platforms, individual investors organized their activities and discussed how to hurt the institutional investors the most.
Retail investors were long considered unimportant on the market when compared to major hedge funds and their impact. They saw this as a way to bring them back on the map and show their importance. The GameStop saga helped them gain significance, and it encouraged many individuals to start retail investing careers.
This case showed how social media can speed up and organize activities and actions, and if used properly they can challenge even the biggest institutional investors on the market.
Also, it pointed out the need to reevaluate long-term market dynamics pushing institutional investors to pay more attention to retail traders. This came hand in hand with identifying trends that these small retail investors often pushed below the radar.
Later Developments
Trading app Robinhood shut down options to buy GameStop stock causing a major controversy. They backed their decision by being unable to post sufficient collateral at clearing houses, so they could execute clients' orders. This was seen as a form of market manipulation.
Later thirteen more entities including several trading platforms became a part of the Congressional investigation. In January 2022 the court ruled that investors could not pursue negligence and breach of fiduciary duty. The same judge dismissed accusations of collusion between Citadel Securities and Robinhood.
Impact Of The Short Squeeze On Market Regulations
GameStop's short squeeze again raised concerns about potential market manipulation in the wider financial community. Both investing sides were scrutinized. Individual investors and Reddit traders could organize through social media, and hedge funds which often resorted to shorting due to the bullish perspective of the market.
Shorting practices were frequently kept in the shadows by the asset management companies, and the SEC began tougher scrutiny of these operations.
Regulatory bodies started monitoring social media platforms and online forums where smaller investors discussed investing activities.
Also, wealthy investors believed and called for enhanced reporting requirements for short positions. The SEC listened to them and deployed a new set of rules for institutional managers.
Since January 2 2024 managers will have to report a monthly average of daily gross short positions if they are at least $10 million or 2.5% of the issuer's outstanding shares.
All securities that are exchange listed and also over-the-counter classes will be included in the new 13f-2 rule. While before the rule SEC scoped only U.S. listed equity securities, now they are also including non-U.S. listed ones.