The GameStop Short Squeeze - Explained

Opinion Analysis by Sandro Joseph Azzam, Staff Writer

March 18th, 2021

The only way you didn’t hear about this happening is if you live under a rock. In late January 2021, the world witnessed a short squeeze on GameStop stock. If you ask me, the last time I heard of the company was when I was 12 years old, trading in half a dozen games for 67 cents. Now that their stock price skyrocketed as a consequence of what we call a short squeeze, GameStop is back on the map and while a lot of people participated in making the squeeze possible, very few individuals understood what was going on.

Time to break down the term “short squeeze” into, well, short and squeeze. To understand that, we must first understand the notion of short-selling in financial markets. 

Essentially, short selling a stock means you sell a stock you don’t own with the hopes of the price going down at a later date so you can buy it back and pay off the guy you borrowed it from. Let’s introduce short-selling by explaining a different concept: arbitrage. Assume your friend lends you a chocolate bar and wants you to give it back to him later today. You sell that chocolate bar to your brother for $2. But when your friend asks you for his chocolate bar back, you go and buy a new one from someone else for $1. Once you have that “new” chocolate bar, you can give it back to your friend. Think of what you paid and what you received. You paid $1 for a chocolate bar and received $2 for a chocolate bar. You essentially made $1 off of the process. 

Now that we understand the dynamics of the transaction, let’s take it a step further, into what short selling is in essence. Alex owns 1 share in a company, say, GameStop. The share is valued at $5. Bobby, an investor, borrows 1 share of GameStop stock from Alex and promises to return it to him one month later. So far, Bobby owes Alex one share in GameStop. When Bobby borrowed the share from Alex, 1 share of GameStop was worth $5. Bobby then goes and sells the share of GameStop to another person, Charlie, for $5. Bobby sold Charlie a share that wasn’t his to begin with. Alex is still owed one share; Bobby owes Alex one share and Charlie holds one share. You can see that there’s a problem here… What happens when Bobby needs to return the share to Alex? Fortunately for Bobby, GameStop’s share price has decreased to $4! He can then go onto the open market and buy one share of GameStop. Now, Bobby has acquired the stock that he owes Alex and can give it back to him. At the end of the whole process, Alex has his share back and Charlie has bought a share from Bobby at $5. What’s in it for Bobby? Well, he borrowed a share from Alex and sold it to Charlie for $5. Once the price of the stock went down to $4, Bobby bought a share from a random individual and paid $4 for it. He then gave the share back to Alex closing off the cycle. Bobby sold something he didn’t own for $5 and then bought the ownership for $4. He profited from the difference between $5 and $4. Why? Well, again, think about what you paid and what you earned. You paid $4 to acquire ownership of the stock when you needed to return it to Alex, but you earned $5 by selling it to Charlie a few days prior. Your profit is the difference between what you paid and what you made, hence, $1. Someone who has a short position in a company wants the stock price of that company to go down, otherwise they lose money. Why?

Well, let’s look at the flip side: what if GameStop stock went from $5 to $6? Bobby borrows a share of stock form Alex when the stock is trading at $5. He then sells it to Charlie for $5. In a month, when Alex wants his stock back, he gives Bobby a call. Bobby knows that there’s a problem right away. He finds out that GameStop stock is trading at $6 a share now… Yikes… Bobby has to go onto the open market and buy a share for $6 to pay off a liability towards Alex that’s only worth $5. Think of the profit that Bobby has made in this situation. He sold the stock for $5 and thus received an inflow of $5. He also bought the stock for $6 and thus incurred an outflow of $6. The outflow is larger than the inflow which means that Bobby has lost $1 on this transaction. He was hoping that the stock price would go down, but unfortunately, the stock price went up and Bobby lost money. 

Let’s now look into the geeky characteristics of these transactions. To simplify the whole thing, we’ll just look at Bobby’s payoff and consider it to be the difference between the price today and the price in one month. Bobby shorted the stock last month when it was trading at $5 and it went down to $0. Bobby made $5-$0 = $5 off of the operation. His gain is limited – in the best-case scenario, the stock price goes to $0 and his profit ends up being the amount he sold the stock for initially. On the flip side, if Bobby shorts the stock today at $5 and next week it ends up going to $9, then Bobby loses $9-$5=$4 on the transaction. But what if the stock price goes up to $10? $20? $50? $100? The losses that arise from shorting a stock are unlimited – if the stock price goes up, and up and up to, say, $1000, you end up making $5 - $1000 = -$995, which is a massive loss. This stems from the fact that stocks can potentially go up to an infinite level whereas they can only go down to zero. When shorting a stock, this plays to your disadvantage: the stock can go up to infinity which means you can lose big amounts whereas if the stock goes to zero, in the best-case scenario, your gain is limited. 

Now, let’s explain the concept of the “squeeze”. When Bobby needs to return the share of GameStop to Alex, he needs to go onto the open market and buy a share. He absolutely must do so, no matter how high the price is. You may see where I’m going with this… If you have to buy something, no matter what, it means that you are willing to pay any price to make it happen and if a lot of people go in and buy the stock, demand will be high which means that the stock price will doubly rise. 

Now onto what happened in January. A hedge fund called Melvin Capital had decided to short GameStop stock: they were hoping the company’s stock price would go down to 0. In parallel, deep on r/wallstreetbets, a subreddit on the Reddit social media platform, an army of people decided to declare war on Wall Street. They knew that Wall Street had shorted GameStop’s shares. In a coordinated move, thousands of people went and bought GameStop stock, which made the price go up through supply and demand. When the price of a stock goes up, the people who hold the stock (i.e. those who hold a long position) make money whereas the people who shorted the stock (such as Melvin Capital) lose money. 

Melvin had opened its position earlier last year, hoping that the stock price would go down to zero as the ill-performing GameStop’s stock was already on a downwards trend. Whilst we don’t know at what price they shorted the stock at, let’s assume for the sake of simplicity that it was $5, which is around what the stock was worth in early 2020. Then, they got a punch in the face when GameStop decided to go from $5 a share rocketing to almost $500 a share, meaning that Melvin lost $495 per share. Given that hedge funds typically buy and sell stocks in the orders of millions of shares, you can see why losing close to $500 per share is problematic… When the stock price was already high, Melvin Capital had to close their position or go bankrupt prompting them to buy the stock (aka return it to “Alex”) at a high price, driving the price up even higher. After the hype and coordinated action ends, the stock price falls back to its natural level eventually, albeit slowly. 

r/wallstreetbets’ war on Wall Street almost bankrupted Melvin Capital, with the firm losing 53%. Main Street cheered when this happened, thinking that they were harming the bankers behind the firm. Unfortunately, this couldn’t be further away from the truth… Whilst the bankers lose money, the real losers are everyday men and women. Why? When the Fire Department of Gotham collects pensions from their fearless men and women, they end up sitting on a very large amount of money. Thus, the pension fund needs to be invested with hedge funds such as Melvin Capital. When it loses money, the pensions of the firemen and firewomen end up being the biggest losers…

The short squeeze that occurred in late January was not the first-time something like this happened. It happened with Volkswagen in 2008, making the automaker the world’s most valuable company… for one day only. While Main Street considered this a victory against the shrewd bankers, it ended up costing everyday men and women their pensions. If Main Street continues its coordinated actions against Wall Street and attempts to bankrupt one hedge fund per week, it’s only a matter of time until we witness the long-term consequences on the real economy.