A Look at the GameStop Boom: What’s Happening and What We Can Learn From It

A Look at the GameStop Boom: What’s Happening and What We Can Learn From It

Dave Abate, CFP®, Senior Wealth Advisor

Even if you’re not totally tuned into the investing world, you’ve likely been hearing a whole lot about GameStop the past few weeks. You may be wondering what all the talk is about and what is actually happening with the stock.

In short, several elements converged at just the right time to create a perfect storm. Here’s a breakdown:

1. Excessive shorting set the stage. Institutional hedge funds became greedy, shorting approximately 140% of GameStop’s float (the number of shares available to be bought and sold by the general investing public). Institutional hedge funds involve actively managed assets held exclusively by institutional investors, who trade securities in large quantities and thus qualify for perks like lower fees.Short selling is used when investors speculate on the future decline in a stock price. When an investor “shorts” a stock, the individual “borrows” it at the current price and sells it with the promise to buy it back in the future in the hopes they will be doing so at a lower price. Essentially, the investor who “shorts” is betting the stock price will decrease in the future.This borrowing is done on margin, meaning the amount an investor can borrow is limited by the borrowing power in their account which is a percentage of the assets within their portfolio.

   For example, if an investor shorts a stock trading at $10 and that stock price drops to $4, their profit is $6. However, if that stock price rises above $10, their loss potential is unlimited, especially considering the interest they will owe to the broker.

2. The pandemic fueled retail investing. The coronavirus pandemic bred boredom for retail investors as they were forced to spend more time at home. Some of these retail investors formed an online community called “r/wallstreetbets” on the social internet forum Reddit. They hatched a plan to identify a heavily shorted stock and coordinate waves of massive buying, encouraged by a barrage of memes on social media.The introduction of commission-free stock trading, investing apps that attracted first-time millennial investors (such as Robinhood) and stimulus checks looking to be spent all helped to bring this plan to fruition.
3. Margin calls increased demand. The buying demand for GameStop stock pushed the stock price up. As the price increased, the hedge funds, who had been shorting the stock, began facing enormous losses and receiving margin calls on their accounts – meaning they were being forced by their custodian to close out their short positions (by buying shares of GameStop) because they no longer had enough borrowing power available to hold the short positions. Hedge fund Melvin Capital reported a 53% loss in January, totaling $4.5 billion. This phenomenon is known as a short squeeze.As the hedge funds bought more shares of GameStop to close their short positions, the price of GameStop raced higher and higher, creating a high velocity feedback loop. The stock price of GameStop became completely detached from the company’s underlying fundamentals.For reference, GameStop opened the year (1/1/21) at $18.84/share and reached an intra-day high of $483/share on 1/28/21. Fast forward to 2/12/21 and GameStop closed at $52.40/share. This is an example of a classic bubble formation.

What can we learn from the GameStop frenzy?

Even if you don’t dabble in shorting stocks, there are several critical investing lessons we can take away from these recent events:

• Understand the difference between speculative trading and investing.
• Develop an investment strategy that is properly aligned with your financial goals and risk profile.
• Always be disciplined – have an exit strategy before you place a trade.
• Understand the value of diversification and the risks of overconcentration.

For more information on the GameStop phenomenon or insight on how to evaluate investment opportunities, give your advisor a call at 216.800.9000.