The Short Squeeze, Stonks and Democracy

POMERANTZ MONITOR | JANUARY FEBRUARY 2021

By The Editors

As this issue of the Monitor goes to press, the stock market continues on a wild ride that began with hedge funds shorting the stock of GameStop, a struggling company whose brick-and-mortar stores sell video games in shopping malls.

To short a stock is to bet that its value will go down. An investor borrows a stock, sells it, and then buys it back to return it to the lender. If the stock is less expensive when the investor sells, the investor profits. Sophisticated investors might identify a flaw in a strong company’s operations before the rest of the market and short its stock, betting that their prescience, once it plays out, will pay big. Noting the flaws in GameStop’s business model, however, did not require much discernment. Expecting customers to travel to strip malls to buy a physical product in the digital age is tilting at windmills; add a pandemic and it becomes a Herculean task. But even though GameStop’s shares were already low when the hedge funds swept in, even a small per share profit, when multiplied exponentially, adds up.

Meanwhile, day traders, transacting in stocks on their cell phones via online, no-fee platforms like Robinhood and E-Trade, were watching the hedge funds watch GameStop. Convening on online message boards such as Reddit’s WallStreetBets, they determined to stick it to the man — namely, the hedge funds — and make some quick money while doing so. Over several months, a large, broad, and loosely cohesive group of day traders devised a strategy for a “short squeeze”: they would buy volumes of GameStop shares to push up its price, and in so doing force the hedge funds to cover their position by rushing to buy back shares, which would further push up the price.

Many of the amateur investors have been placing option bets to bet against the shorts. A call option is a contract that gives the owner the right to buy a specific amount of stock at a specific price by a specific future date. If the price rises, the trader can buy the stock at the set price — now a bargain — and sell it for a profit (or sell the option contract itself). The brokers who sell the options, as a rule, own enough stock to be ready when traders exercise their options. In the GameStop scenario, where the price skyrocketed, those brokers, too, have to buy more stock now to mitigate the burn of having to buy too many expensive shares at one time later. This increases demand, which again increases the price.

The financial flash mob’s plan worked. Shares of GameStop skyrocketed 400% in the last week of January, ending the month with a staggering 1,625% gain. At least one hedge fund, Melvin Capital Management, having lost billions, threw in the towel on its GameStop position. Keith Gill, the 34-year-old suburban father and financial adviser who ignited the GameStop buying frenzy with YouTube videos under the name Roaring Kitty, is now — at least on paper — a multimillionaire.

Meanwhile, a day after GameStop shares rose 135%, Robinhood, the free-trading pioneer purportedly founded to democratize trading, restricted trading on its app in GameStop and other highly shorted securities, only allowing users to close out their positions, while those investors not tied to their app were still free to invest. Robinhood, which is backed by venture capital, said in a statement that these restrictions were made to comply with the regulations that govern it, including capital obligations mandated by the SEC. Indeed, over the last few days in January, Robinhood raised $3.4 billion, most likely to cover heightened margin requirements that may have been imposed by the Depository Trust & Clearing Corporation, the central clearing facility for the stock market.

Day traders staged protests, accusing Robinhood of being in league with the “suits” of Wall Street. The broker’s move also engendered rare bipartisan accord in Congress, with both progressive Democrats and populist Republicans condemning Robinhood. Democratic Senator Elizabeth Warren said:

What’s happening with GameStop is just a reminder of what’s been going on on Wall Street now for years, and years and years. It’s a rigged game. We need a market that is transparent, that is level and open to individual investors. It’s time for the SEC to get off their duffs and do their jobs.

The GameStop story, though, is not simply a tale of Wall Street vs. the Degenerates (as the community on Wall- StreetBets call themselves). Elon Musk, the richest man in the world, fanned the fires with a single-word tweet on January 26 and a hyperlink to WallStreetBets. The word? Gamestonk. Stonks, an intentional misspelling of stocks widely used on Reddit forums, mocks Wall Street’s seriousness, and Musk’s tweet made him an unlikely anti-establishment hero to Redditors.

Some day traders have claimed they bought GameStop for “lolz” — the fun of it. Others jumped in for FOMO once the price started to soar. But many cite having been embittered by the 2008 financial crisis, the subsequent bailout of the big banks, and the failure to hold those responsible accountable.

At the time of writing, it remains to be seen where the GameStop saga will end. Some hedge fund CEOs have had their eyebrows singed, a few day traders got rich, but many analysts predict that those day traders who still have long positions will lose big.

How efficient is a market in which the value of a stock has no relation to a company’s fundamentals? And what can regulators do when an inflated price is not the result of fraud? The SEC now finds itself in the position of seeking potential areas of liability. As Dean Seal wrote in Law360, “The novelty of the situation itself will stand as a test for a regulator in transition — determining what role the SEC has in a seemingly ideological trading war between the mom-and-pop traders it is sworn to protect and the old guard of Wall Street.”