GameStop, Reddit, and Market Mania: What Happened?
GameStop, Reddit, and Market Mania: What Happened?Over the course of 11 trading days in late January 2021, the stock of GameStop, a struggling brick-and-mortar video game retailer, skyrocketed by more than 2,200% — creating a mix of excitement and concern throughout the financial world.1 Other stocks of small, struggling companies made similar though less dramatic moves.
At the heart of this story are two very different sets of investors: (1) professional managers of multibillion-dollar hedge funds, who took large, risky positions betting that GameStop stock would drop in price; and (2) a small army of individual investors, connected through social news aggregator Reddit and other social media sites, who worked together to buy large numbers of shares in order to drive the stock price up. The opposing forces created a feeding frenzy that sent the stock to dizzying heights far beyond the fundamental value of the company.2 The price peaked on January 28 and lost almost 90% of its peak value over the next five trading days before leveling off.3
Here are answers to some questions you may have about the market volatility triggered by “meme” stocks, an Internet term for stocks heavily promoted through social media.
What Were the Hedge Funds Doing?
A hedge fund is an investment company that uses pooled funds to take an aggressive approach in an effort to outperform the market. These funds are typically open to a limited number of accredited investors and may require a high minimum investment.
In this case, certain hedge funds borrowed shares of GameStop from a brokerage firm — called borrowing on margin — and sold the shares at the market price, with the expectation that the share price would drop significantly by the time they had to return the shares to the lender. The funds could then buy shares at the lower price, return the shares, and pocket the difference (minus fees and interest).
When GameStop share prices rose quickly against expectations, the “short sellers” began to buy shares at market prices in order to protect against future losses and meet margin requirements, a percentage of borrowed funds or securities an investor must keep in a margin account. These purchases drove share prices even higher, which led to more purchases and even higher prices, a situation known as a short squeeze. Because there is no limit to how high a stock price might go, there is essentially no limit to the potential losses for a short seller.4
Wild Ride
Price of GameStop stock (GME)
Source: Yahoo! Finance, 2021, for the period 1/13/2021 to 2/17/2021. Includes open, close, and intraday highs and lows.
What Were Reddit Investors Doing?
Reddit is an online community with forums called subreddits in which members share information on a topic. Members of a subreddit dedicated to investing coalesced around a strategy to buy GameStop stock in order to push the price up and squeeze the hedge funds. While some investors believed that GameStop was undervalued, the movement developed into a crusade to beat the hedge funds in what amateur investors perceived to be a “game” of manipulating stock values, as well as a more pragmatic belief that there was money to be made by buying GameStop low and selling high.5
The strategy worked more powerfully than the amateur investors expected, and some who bought the stock in the early stages of the rally and sold when it was flying high earned large profits. However, those who joined the excitement later faced large losses as the stock plummeted. Once some hedge funds had accepted losses and begun to close their short positions, there was no longer demand for shares at inflated prices.6
Why Was Trading Stopped?
During peak trading activity, some brokerage firms stopped the trading of GameStop and other heavily shorted and heavily traded stocks. They also placed restrictions on certain stocks, limiting trading to very small lots and/or raising margin requirements. The stoppages and restrictions elicited accusations of unfairness from investors and some members of Congress, who believed the brokerage firms were protecting the hedge funds.7
In fact, the moves were dictated in large part by clearinghouses that process trades from brokers. These clearinghouses require that brokers keep a certain level of collateral on deposit to cover both sides of any given trade. As trading and values increased, clearinghouses asked for larger deposits. By halting and/or restricting trading of highly volatile stocks, brokers were able to reduce the required collateral, which enabled them to meet the deposit requirements in a timely manner. The restrictions also helped protect investors from suffering outsized losses amid extreme volatility.8
What Happens Next?
One takeaway is that social media, combined with accessible low-cost trading platforms, allows like-minded groups of retail investors to exert power that matches large-scale institutional investors. Some hedge fund managers have already stated that they will rethink their focus on short selling.9 And new services providing tools for professional investors to track investing discussions on social media platforms may become a staple of investment research.10
Although the larger stock market remained resilient, extreme volatility is always a concern, and the Securities and Exchange Commission and other regulatory authorities are investigating the events.11
The lesson might be to tune out market mania over “hot stocks,” especially when there is little behind the sudden interest other than speculation. The wisest course is often to build a portfolio appropriate for your risk tolerance, time frame, and situation, and let your portfolio pursue growth over the long term. This strategy may not be as exciting as the wild ups and downs of stocks in the spotlight, but it’s more likely to help you reach your long-term goals.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments offering the potential for higher rates of return also involve higher risk.
Margin accounts can be very risky and are not appropriate for everyone. Investors must meet certain financial requirements in order to establish a margin account and accept the increased risk. Before opening a margin account, you should fully understand that you can lose more money than you have invested; you may have to deposit additional cash or securities in your account on short notice to cover market losses; you may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.