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Lock, Stock and Two Smoking Barrels

This is the story of GameStop – one of the greatest short squeezes the world has ever seen. But what is a short squeeze? And why is it a big deal? Read on.

1.     The Most Valuable Firm in the World and a classic ‘Switcheroo’

Back in 2008, at a time when the world was reeling from the effects of the global financial crisis, there was a German automaker named Volkswagen that wasn’t performing too well. The premium on its ‘ordinary’ (common) shares had risen to extremely high levels as compared to the preference stocks (which offer a fixed dividend on a monthly basis), giving major hedge funds ample opportunity for arbitrage. The idea for the arbitrage (i.e. making a profit from the difference in prices of the two kinds of stocks) was simple: sell the ordinary shares and buy dividend-yielding preference shares instead.

Working in the background, however, was German automaker Porsche. Porsche silently (and swiftly) went about acquiring the ‘ordinary’ VW stock, until on one weekend, Porsche announced that only 6% of VW ordinary stock was left as ‘free float’ in the market: at a time when short sales for the same stock was at 12%.

A short-seller of stock works on a fairly simple principle: an investor ‘borrows’ stock from a firm, sells it at a price in the market, and then buys the actual stock eventually to pay back to the firm. Now, this entire process makes sense if at least both of the following criteria are met: first, that the stock price goes down eventually so that the investor can buy it at a lower price (than what they borrowed it for) to pocket the difference in prices as profit; and secondly, (and perhaps more importantly) that the stocks (to be purchased) indeed exist in the market. Essentially, what Porsche’s manoeuvre had guaranteed is that it would become mathematically impossible for every short-seller of the stock to buy a share to close out their position.

Understandably, a panicked dash ensued — the demand for the stock, pushed by short-sellers looking to close out their position — suddenly far outweighed the supply of the stock. Over a weekend, stock prices for VW had risen from 210 a share to almost 1000 a share — even temporarily raising its valuation enough to make Volkswagen the most valued company in the world.

The biggest losers here — subject of this aptly called ‘short squeeze’ – were major Hedge funds who had lost an estimated 30 billion by betting against VW ordinary shares. Ironically, however (after the market madness had subsided and VW stock prices stabilised), Porsche could not close out the long position it had assumed in the firm and had to be acquired by Volkswagen instead – one of the most famous ‘switcheroos’ in the history of trading.

Over a decade later, GameStop today stands in direct competition to VW — to become, arguably, one of the greatest acts of internet mobilisation against Wall Street, ever.

2.     The Greatest Short Squeeze ever?

GameStop is an American video game-store chain. It is a brick-and-mortar-based organisation that deals in videogame software and hardware, and understandably, isn’t expected to turn a profit until 2023. The logic is simple: even before the Covid-19 pandemic, the sale of video game paraphernalia had majorly shifted to online stores — a trend only pushed forward by the pandemic. Valuation and stock prices for GameStop (GME) were low and were expected to move in only one direction — downward. Short-sellers (including major Hedge Funds such as US-based Melvin Capital and Citron Research) had bet on exactly this and things had, in fact, worked out rather well for them through the last year (until last week, that is). In fact, Bloomberg even referred to GameStop as a ‘cash register for bearish traders’: turning profits for all short-sellers involved in its sale and purchase. This was, of course, until certain internet users based out of a subreddit called ‘WallStreetBets’ (WSB) decided to turn the entire game on its head.

In manner akin to Porsche’s accrual of VW shares in 2008, hordes of online traders (members of the subreddit WSB and bored at home during lockdown), banded together to create what may perhaps be regarded as one of the greatest short squeezes ever seen. The banding together of these investors (over trading apps such as Robinhood) ballooned the valuation (and stock price) of GameStop incredibly – causing it to triple to $4.5 billion in a matter of three weeks: not too shabby for a firm not expected to turn a profit before 2023 (one would think).

2.1 WallStreetBets and the Right Valuation

Tracing backwards, one can find inklings to such a phenomenon taking place to a post on the WSB subreddit almost twenty-two months ago. A Reddit user by the name ‘delaneydi’ had posted an in-depth valuation of GameStop stocks on to the WSB forum. Delaneydi believed that the GameStop stock was massively undervalued: with its valuation not accurately depicting its current earnings power and its large continent cash hoard. The view, however, mostly fell on deaf ears, as GameStop stock continued to fall by 15%, 12%, 28% and 27% (respectively) in consecutive months between April and July of the year and continue to enrich bearish traders and short-sellers. There were, however, two events of note that took place that year.

Figure 1: GameStop Investment Thesis, by user ‘delaneydi’; Source: Reddit

According to Bloomberg: “One was Michael Burry –- of Big Short fame and the veritable spirit animal for internet stock gurus hoping to hit the big time –- saying he was long (on) the shares through his fund Scion Asset Management. Second was the surfacing of an idea, first in jest, that eventually evolved into the blueprint for the crowd-sourced short squeeze that has blown up in January (2021). Could GameStop fall so far as to make a takeover possible — by WallStreetBetsitself? It would only cost about $45 million to buy up the entire float if the stock dropped to 50 cents a share, said user MGE5 in a June 5, 2019, post.

The stock closed at $5.04 that day, but after a 36% plunge from the day prior anything seemed possible for one of Wall Street’s most hated stocks. The notion was met with derision and sarcastic suggestions typical of WSB’s usually juvenile ambience, but the genie was out of the bottle. What if the renegades could gang up to flood a single security?”

2.2 And, oh did the Renegades gang up!

Ensuing posts by the ‘de facto champion’ of the GME case on the WSB subreddit: a user by the name ‘DeepF***ingValue’ (name edited), uploaded a picture of his winnings post-Michael Burry’s acquisition of long stocks of GME. “While the battle was far from won, DeepF—–gValue…became the first to show that there was money to be had in those empty aisles flanked by video game discs Wall Street analysts said no one needed to buy.”

This was, however, no guarantee of success. Although stocks rallied on through August and until October 2019, it went sideways until the end of the year, followed by the massive dip forced by the Covid-19 pandemic. A watershed moment, however, was to follow soon.

On April 13, 2020, a user going by the handle, ‘Senior_Hedgehog’, made two rather astute observations in a post on the WSB subreddit: first, he observed that 84% of GME shares were held short. Secondly, (and in all caps) he implored GME owners to call their brokers and tell them not to lend their stocks short on the market (i.e. to not allow their stocks to be ‘borrowed’, as happens in a short-sell). The time, according to Senior, was right to wage ‘war’ on the rich and powerful short-sellers of Wall Street.

Figure 2: Rally call, by ‘Senior_Hedgehog’; Source: Reddit

And, it did not take long. Bloomberg Wealth writes: “Shares rallied 22% on the day of Senior_Hedgehog’s short squeeze post. The next day they soared by another 26%, the biggest gain in at least 18 years at that time, while volume was more than five times the 20-day average at one point during the day.”

The tipping point came soon after: with Ryan Cohen (co-founder of US-based Chewy Inc. and bit of an internet trading cult hero) disclosing that his firm RC Ventures had acquired a 5.8 million-share stake in GameStop. Shares surged 24% that day and kept rising steadily: reaching $65.01 in January 2021 from the single-digit prices observed in September 2020.

2.3 “Bankrupting Institutional Investors for Dummies, ft GameStop.”

WSB users treated the GME case as the biggest opportunity to upset the large institutional investors of Wall Street. Users soon figured out the massive short positions held by hedge funds such as Melvin Capital and Citron Research on GME. In fact, Citron even came to be regarded as ‘WSB Public Enemy #1’. Users soon realised the losses being incurred in their portfolios because of GME stocks rising in price: and thus came in the new narrative of the exercise that stands true to this day: this was going to be an exercise to hurt the largest institutional investors as much as they could.

Figure 3:Citron was called Public Enemy #1Source: Reddit

A revolution of sorts came to be afoot – with more and more people moved by the idea of hurting the rich and powerful. Mobile trading app Robinhood became the primary tool as GME stock prices rose from around $17 to a peak of $347.51 (reached on January 27, 2021). The ‘revolution’ saw challenges as well, with the temporary banning of GME stock trading on the Robinhood app causing a temporary fall in prices. This was, however, met with an immediate and subversive cry to reopen trading from several corners, questioning Robinhood’s stance on the democratisation of finance.

Figure 4:The reactions were strongSource: Reddit

As it stands currently, stock prices have, in fact, rallied once again, with GME stock trading at $325 at the time of writing. The degree of planning that went behind the stock surging 870% in a week – a remarkable number that forced losses of almost $20 billion to short-sellers in January 2020 alone – was objectively, of course, an astonishing feat (depending on who you ask). The future of the GameStop saga — and the sustainability of these astonishingly high stock prices — is going to be anyone’s guess. But one thing is for certain: the power they took from the people, has indeed, returned to the people.

Do I hear anyone cheering “Long Live the Revolution”?

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