What started as a joke, ended up bringing Wallstreet to its knees.
In the last few days, you made have heard phrases like “shorting” and “wall street bets” for the first time. You may also have heard about GameStop for the first time in 10 years. What started as a joke on Reddit has turned into a few thousand people turning $30 into $3,000 and several large hedge funds losing tens of billions of dollars.
Let’s start with the basics:
What is “shorting” a stock? Shorting a stock is borrowing a stock and selling it with the promise of buying the share back, hopefully at a lower price, to give back to the original owner. So let’s say company XYZ is currently selling at $100 a share and you think it is overvalued. You, through a broker, can short that stock for $100. A few days later the stock value drops to $10, the broker then buys back the stock for $10, and you, the person who originally shorted the stock, make a profit of $90. What makes shorting dangerous is that it is the inverse of normal stock buying. Usually, the worst possible outcome when you buy a stock is that its value goes to zero and you lose all of your initial investment. But if you were to short a stock, hypothetically your losses could rise infinitely as the price of the stock increases.
Now, with that out of the way, here is what actually happened:
Two hedge funds, Melvin Capital and Cirton Research took up heavy shorting positions on the video game company GameStop. This sort of thing happens fairly often, especially in firms that specialize in shorting stock. What was different this time, however, was, first, the hedge funds were in a particularly vulnerable position, since GameStop was selling at only about $33 a share. Second, the good people at the Reddit community WallStreetBets, a tongue-in-cheek stock trading and buying forum, caught wind of this maneuver. Because the stock was so cheap, people in that community were able to buy up thousands of stocks, causing the price of the stock to rise at an incredible rate. This is called a short squeeze, and it is devastating for the hedge funds. So, on January 27, Melvin Capital and Cirton Research were forced to close on their shorts, costing them billions of dollars and allowing retail traders to be holding stocks that have increased in value by 700%.
As of this writing, the situation is very fluid. Most of the retail investors are holding their stocks; not selling despite the high value of the stocks and hoping for another squeeze that will send the value skyrocketing again. The app that allowed amateurs to buy and trade stocks, Robinhood, has closed trading on GameStop stock—thereby managing to draw the ire of both Senator Ted Cruz and Congresswoman Alexandria Ocasio-Cortez and possibly forcing the heads of Robinhood to appear before Congress.
Keep an eye on us at OCN for more information about this as the story develops. Do you know anybody who has invested in GameStop? Let us know in the comments.