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Blog | The GameStop ‘short squeeze’ that hedge funds never saw coming

Andrew Hewison
Managing Director
3 Feb 2021

Who else has been following the David and Goliath battle between a sub-set (Wall Street Bets) or content platform, Reddit, versus some Wall Street Hedge Funds? Make no mistake, a movie will be made about it in years to come. In the meantime, let me help explain it.

Who is GameStop? It’s a bricks and mortar retail gaming chain in the United States. Like many bricks and mortar retail businesses, GameStop fell dramatically as Covid took hold forcing retailers to close, some permanently.

In February 2020 it was as low as $3.95, but last week it rose to $347. Why?

Here’s where it gets interesting. Throughout 2020, Wall Street Hedge Funds had taken out short positions in GameStop.

Have you heard of short selling before?

It’s essentially where Hedge Funds borrow the stock of a particular company at a certain price, say $20, and sell the borrowed stock on the market forcing the price down, to say $5. It then buys the stock back at $5, profiting $15. Therefore, their profit is the difference between the borrowed price and the price they physically paid.

Hedge Funds typically take out short positions on companies that they believe are overvalued and profit when the company falls. Some believe short selling is a healthy check on the market to ensure companies do not become incorrectly overvalued.

Based on the above assumption, we should all believe that Hedge Fund managers are noble humans looking to protect the little guys. Said no one, ever!

No, Hedge Fund Managers aren’t those people. They are more likely to sell their own mother for a profit (allegedly), or, would happily drive a company’s share price to essentially zero to maximise their profit at the expense of the little guy and anyone else in the way.

That’s where a group of investors from Reddit come into play.

For almost 12 months now, these investors believed that GameStop had the potential to turn around as it focused on sales via its digital platform and away from retail stores. They also happen to know that the stock was being extremely heavily shorted by Wall Street Hedge Fund Managers.

What we saw last week was the beginning of what they call a ‘short squeeze’. That is, where the price of GameStop exceeded the share price the Hedge Funds had borrowed the stock at. The higher the share price of GameStop, the greater the losses suffered by the Hedge Funds. These losses can be infinite if the share price continues to rise.

The Hedge Funds can either call the bluff on the market and wait for the GameStop share price to fall or begin buying the company themselves joining those investors who have jumped on the bandwagon. The more likely scenario, as we saw last week, is that the Hedge Funds will begin closing out their positions to minimise the losses on that particular position.

Some trading platforms in the US, such as RobinHood, froze the ability of their users to buy GameStop which created a furor as it has been alleged that RobinHood felt the pressure from Hedge Funds to freeze purchasing.

This story is far from over. As it seems the Hedge Funds still have huge positions in GameStop and hence why many retail investors, including investors on Reddit, are continuing to take long positions in GameStop in the belief that the share price will continue to rise.

The reaction from the Hedge Funds themselves has been absolutely hilarious. They are now crying poor and asking for more regulation over the industry, simply because a group of retail investors on Reddit have taken them on and are beating them at their own game.

Make no mistake, short selling is nothing more than market manipulation and outright gambling. Perhaps more on that later.

For now, like many others, I will sit back with my popcorn, and bated breath, to watch this unfold in the coming weeks.

Hewison Private Wealth is a Melbourne based independent financial planning firm. Our financial advisers are highly qualified wealth managers and specialise in self managed super funds (SMSF), financial planning, retirement planning advice and investment portfolio management. If you would like to speak to a financial adviser on how you can secure your financial future please contact us 03 8548 4800, email info@hewison.com.au or visit www.hewison.com.auPlease note: The advice provided above is general information only and individuals should seek specialised advice from a qualified financial advisor. The views in this blog are those of the individual and may not represent the general opinion of the firm. Please contact Hewison Private Wealth for more information.