The GameStop Short Squeeze Saga: Understanding the Underlying Mechanics
A GameStop store is seen in St. Louis, May 7, 2020.Jeff Roberson/AP, FILE
In January 2021, a short squeeze of the stock of GameStop caused major financial consequences for certain hedge funds and large losses for short sellers. So what happened to cause this? GameStop is an American video game, electronics, and gaming merchandise retailer and like most stores that sold products in person during the Covid-19 pandemic, it struggled with its sales. Many companies that were in a rough state during that time, GameStop was subjugated to short selling. Of course, short selling wasn’t the only reason for GameStop’s price movement. However, the entire situation couldn't have happened without a significant amount of money being placed into shorting the stock. It is important to understand the mechanics of short selling as this significantly influences the price action.
Short selling a stock allows professional investors to gain profit by borrowing shares of a stock, selling them and then buying them back later so they can return them, which lets them keep the difference if the stock price goes down. They're basically bets that the company will fail. For example, Company A has decided to go public, which means its company shares are now available to be bought by investors. Let’s imagine, that Tom already has a piece of stock in Company A, and his brother Alex believes that the stock price is going down. Alex will want to short the stock and will borrow Tom’s shares in the form of a loan( through a contract) promising to return those shares with an incentive like interest back to Tom. Alex will then sell those shares at their current price of $20 with the intention of then buying those shares back in an open market at a later date at a lower price ($10) to profit from the difference. Alex will return Tom’s loan with their agreed-upon incentive and Alex will have gained a profit ($10-incentive).
However, things don’t usually always go according to plan. So what would happen if the stock price actually goes up instead of down? If we still follow the example mentioned above, Alex still has to return the shares back to Tom, which means that buying the shares back on the open market is now at a higher price than the initial position which means Alex loses money. However, he has no choice other than to cover his situation by buying it. If many investors are in the same situation as Alex in Company A’s stock, all the short sellers will buy back shares at the same time, which can make the price go up even more. As the price rises, more short sellers are forced to buy back shares at higher prices. This creates a cycle where the stock price keeps climbing because of the buying. This situation is called a short squeeze.
So what happened to GameStop? A lot of investors bet against GameStop's stock by short-selling it. So, they borrowed the stock and sold it, hoping the price would go down so they could buy it back cheaper and make a profit. But then, a group of individual investors started buying up a ton of GameStop stock which increased the stock price. This created a short squeeze - the short-sellers were forced to buy back the stock at much higher prices to cover their positions, causing the stock price to skyrocket.
In conclusion, the GameStop short squeeze in January 2021 demonstrated how individual investors can disrupt financial market processes. GameStop’s stock price skyrocketed as a result of extensive short selling by hedge funds and an attempt by private investors to influence the market. This squeeze further aided the stock’s rise in price, driving short sellers to cover their bets by repurchasing shares at a higher price. This incident illustrated how small, individual investors can come together and undermine the power of big institutions, disrupting the market order.
Sources:
Wikipedia contributors. (2024, July 20). GameStop short squeeze. Wikipedia. https://en.wikipedia.org/wiki/GameStop_short_squeeze
Janis Lesinskis’ Blog - A quick introduction to the mechanism of stock short selling. (2021, January 30). https://www.lesinskis.com/quick-introduction-to-short-selling.html
GameStop stock frenzy has Wall Street buzzing: What it means to you. (2021, January 28). [Video]. NBC News. https://www.nbcnews.com/business/business-news/gamestop-reddit-explainer-what-s-happening-stock-market-n1255922
https://www.cato.org/cato-journal/fall-2021/gamestop-episode-what-happened-what-does-it-mean
https://edition.cnn.com/2024/06/12/investing/premarket-stocks-trading-meme-gamestop/index.html