#44 - The GameStop Short Sell Where the Little Guy Beat Wall Street at Their Own Game

Updated: Jul 5, 2021

-Who was behind GameStop's large increase in the stock price?

-Short selling explained and how does it affect the stock market pricing?

-How did the short squeeze affect the hedge funds?

-How did Robinhood and Interactive Brokers react to the stock trading?

Okay so this week we are going to talk about perhaps one of the biggest stories in the United States which is about GameStop.

They have been turning the financial world upside down due to its astronomical share gains which is up about 1,134% for the year as of this recording. Some of you out there may need to assess perform the annual financial check up due to some impressive gains in this stock.

Yeah this is crazy. This is another unprecedented occurrence in the market over the last year, which kind of seems par for the course from 2020 with the Coronavirus; however, it's not that it hasn't happened before, as in stock manipulation, it's just in the way that it happened due to technology and social media.

Without a doubt there have been some people who made a lot of money as well as those who've lost a lot of money.

Who is GameStop?

Okay so let’s explain the basis of what the GameStop story is all about.

If you are not aware, GameStop is a retailer that sells video games and game consoles using the brick-and-mortar model by selling in malls and shopping centers. Over the last several months and perhaps years really, is that GameStop doesn't have a business model to support stock growth and they may not be in business down the road.

Due to technology the main culprit of GameStop's demise has to do with being able to play games digitally. According to gamerant.com 83% of games are played digitally.

Therefore, without even getting into other contributors to GameStop's failing business model, that speaks for itself.

In December of 2020 GameStop announced that they will close 1,000 stores by March 20th of 2021 and they've already closed roughly 800 stores in the past year.

So, Tara just pulled up this stat about their last earnings report and in the last quarter they lost .53 cents per share. So they aren't making money and they have a large debt load.

So that was a quick synopsis but in short GameStop's future hasn’t been looking bright and even if they sustain their business model it would not be a company that would be a darling of Wall Street to invest in.

Now that we have laid the tracks let's ask the question . . . what the hell is going on?

The Short Squeeze

To put it simply GameStop's large increase in share price has to do with what's called a short squeeze.

So to be very simple about the concept, traders place bets on the shares and namely in this case stock options.

To put it simply this type of trading in other words is a legalized form a gambing. It's all about betting which way a stock is going to perform.

When people or entities bet against a stock it's called shorting it. Shorting the stock means that shares are borrowed from a broker on margin, and the broker says I'll give you these shares, but you have to return them later, and pay me margin interest in the meantime.

This means when you short the stock or borrow the shares, you want them to go down in price. Why do you want them to go down, you ask? Because, when that happens the investor can buy the same amount of shares at a lower cost if they do; and if that happens, the investor gets to pocket the difference, meaning I sold the borrowed shares at a higher price, betting that the stock is going to go down, because I don't believe in the company’s stability.

Honestly, this is an age old strategy for more sophisticated investors, and really, there’s nothing wrong with this. It’s not illegal, but you do have to be fully prepared to deliver the shares back to the broker, because you borrowed them to sell.

Short Selling Example

The whole point of short selling is betting on, and profiting from, a drop in a security's price. This can be contrasted with long investors who want the price to go up, because they’ve bought them to hold them for growth and potential income.

Here is a loose example for simplicity. Suppose I plan in my budget to borrow 10 iPhones from Cindy that have a value of $100 each. So then that’s $1,000 in my pocket now because when I borrow them, I immediately sell them to buyers willing to pay $100 for each phone.

Now, on my hunch, I am betting that the market value of that iPhone will drop, thinking a better model might come out, and these will inevitably drop in value. So lucky me, they did go down to $80, now I can go back and buy these iPhones back for $800.00.

In this example, I would pocket $200, and I’d then deliver them back to Cindy to repay her for the iPhones I originally borrowed from her to sell at a profit. Now, that worked out great for me, because the phones did what I hoped they would do; which is lose value!

So let's do this with the stock where there is a loss to the investor that borrowed stock to sell. Let’s say Tesla currently trades at $300 a share and David borrows 20 shares from me. So at that point in time that means those shares are worth $6,000.

Knowing that the whole point is that you want the shares to go down in price, let's say that the shares shoot up to $400 in price. The shares would be valued at $8,000. So in performing the calculation, the stock is sold for $6,000 but the stock went up instead of down, and now David has to buy them for $8,000 so he can deliver them back to me, and now David is $2,000 in the hole. He has to come up with extra cash out of his pocket so he could buy the shares to give them back to me, and he has to pay me interest in the meantime.

So the reason that GameStop has had such a run-up in the stock price is that when the short sellers are losing money it is due to the fact the stock is being purchased by investors in the open market. This drives the price up, and now those short sellers need to close their position. This means they need to buy up their shares to pay them back to the lender, and this creates more buying in the open market, which then continues to increase the stock price due to the demand.

So in short, not to use a bad pun, if a short seller investor doesn't act quickly when a stock starts rising in value, their stock position just keeps getting more and more into the negative because they have to come up with big dollars to buy them back.