[The GameStop Saga - Part I] Capital Uprising

A multi-part retrospective on GameStop, r/wallstreetbets and what we can learn from the aftermath.

This is Something Interesting, an independent, ad-free roundup of interesting Bitcoin and economics news along with my commentary and perspective. If someone forwarded you this newsletter, you can get it for yourself by clicking here.

In this issue:

  • The hedge fund sharks come for GameStop

  • r/wallstreetbets starts by gambling then goes to war

  • The powers that be call a time out

The sharks start circling GameStop

Look it is a tough time for everyone right now but it is an especially bad time for anyone operating a a chain of mall stores that sell physical video game equipment. Consumers are moving online, video games are going digital, coronavirus has turned our malls into abandoned post-apocalyptic movie sets. It is not a great time to be a company like GameStop, and it’s not hard to see why.

In fact those reasons were so obvious and compelling that a bunch of wealthy hedge funds decided bet against GameStop’s stock by borrowing it, selling it and buying it back later (hopefully more cheaply) to repay their loans. The more they could convince the market to be skeptical about the business the greater their profits - if they drove the business completely bankrupt they could even avoid repaying the loan at all!

The hedge funds shorting GME might even have been naked shorting, a kind of illegal fraud which basically works the same way as a regular short except you skip the boring expensive part where you actually find stock to borrow. Here’s Jim Cramer being more direct than he probably intended to be about the whole sordid affair:

Short selling stocks is riskier than buying and holding them. If you invest $X into a company and it goes bankrupt, you can only lose $X. You can’t lose more than you invested. When you borrow someone’s stock to short sell it, though, you are contractually obligated to buy that share back at some point to repay your loans - no matter the price. There is no limit on how much you can lose - a short trade that goes wrong enough can completely bankrupt you.

In spite of that risk, dunking on GameStop’s future prospects seemed like such a surefire trade that a lot of money lined up to short the stock: so much so that at peak there were actually more shorts (and hence more promises to buy GameStop stock in the future) than there actually were shares of GameStop available on the market. That’s a very precarious position - as long as the stock price fell everything would work out fine but if it rose the shorts would be trapped in an overcrowded room stampeding towards a small exit.

A new challenger approaches

Meanwhile independent trader Keith Gill (u/DeepFuckingValue on Reddit, RoaringKitty on YouTube) was doing his own analysis on GameStop’s stock ($GME) and had concluded that the obvious was wrong.

GameStop had challenges but it wasn’t teetering on the brink of collapse. It had cash on hand and a plausible path forward for the future. More importantly there were so many short bets that even a modest price rise would put pressure on the hedge funds to buy stock to cover their shorts at a loss, driving the price even higher and causing a cascading crash upwards known as a short squeeze.

It is a bit hard to remember now but at this point the trade was actually a pretty level-headed financial assessment that the company was being undervalued. Here is RoaringKitty in August of 2019:

Momentum gathers on r/wallstreetbets

RoaringKitty was posting his analysis to r/wallstreetbets (WSB) a community on Reddit dedicated to exotic and aggressive trading strategies and started regularly posting the results of his GME long position and his thinking as it unfolded. Over time other redditors grew increasingly interested - out of curiosity at first but then increasingly because they became persuaded by the case he was making.

Eventually (as sometimes happens on Reddit) the idea went viral. More and more members of WSB joined the position, often multiplying their impact (as well as their risk) by using leverage or buying call options instead of just buying the underlying. GameStop is a small company - there literally aren’t that many shares. So when a sudden surge of demand (augmented by leverage and options) flooded an already thin market, the price of GME started to rise.

GameStop’s stock price rising from the dead created its own feedback loop: the strangeness of the story drew people’s attention, some ended up deciding to buy in, which drove the price up, which attracted more people, etc, etc. The price skyrocketed more than 10x up to ~$65/share. The shameless gamblers of r/wallstreetbets were getting hilariously wealthy at the expense of stodgy old corporate suits!

This is what the price chart looked like:

Nothing unites a mob like a villain

The original case for GME being undervalued was pretty straightforward and reasonable but at this point what was happening was something different and wholly unprecedented. Hedge Funds are not generally used to being pushed around by retail traders and they were buoyed with confidence by the knowledge that there was no conceivable world where the fair market value of GameStop was over $5B. So they increased their short positions and made public statements about how ill advised it would be to try and trade against them:

Oops! I am not a financial advisor but I will say this - try to avoid antagonizing internet mobs. Honestly that goes for other areas beyond finance. Anyway, it didn’t work out here. By making it obvious they held the small retail traders on the other side of the short in contempt, Citron transformed GME from a high-risk moneymaking opportunity into an option contract to make the villains of Wall St bleed. The market for inflicting pain on Wall St turned out to be enormous.

Suddenly buying GME wasn’t a reckless gamble but an act of heroism:

On Tuesday GME was the most traded equity in the world. Everyone from Mia Khalifa to Elon Musk joined in on the excitement. Hedge funds lost billions in shorts. The price chart looked like this:

The grown ups demand a timeout

By Thursday the short squeeze had begun in earnest and the price was soaring. Retail investors were undeterred and piled in from Robinhood and other platforms to buy into the movement - partially because people seemed to be getting hilariously rich but increasingly as an expression of class rage.

At this point the losses for shorts are reaching billions and firms like Citron and Melvin are calling in capital backstops from investors and partners to defend their shorts. This is what it looks like when enormous hedge funds are forced to sell their positions to raise emergency capital or de-risk their portfolio:

    To be clear retail traders were hardly trading alone. Once blood was in the water plenty of billionaires and hedge funds were happy to line up on the other side of that bet along with them. The two largest holders of GME are Fidelity Management and Blackrock Inc - not exactly your mom-and-pop shops. But retail traders were extraordinarily long GME - so much so that it was creating strain not just for the hedge funds who were short but for the markets themselves.

    Then just as GME crossed ~$500/share several things happened at once: trading was simultaneously suspended across several exchanges. The r/wallstreetbets community on Reddit went private and the r/wallstreetbets Discord server was banned. This was all a very fortunate coincidence for hedge funds.

    Here is what the price looked like:

    Next Issue: Robinhood sides with the Sheriff

    Other dumb stuff:

    Share Something Interesting