Reddit Versus Wall Street
What a way to start 2021 indeed. If you are an ardent student of financial institutions and systems, or just an ordinary citizen scrolling through social media, last week’s reporting on the Stock Market brought the country together, mostly in mocking Wall Street and all that it stands for, but most importantly as witnesses to how even our financial institutions are fragile.
If by now you have no clue what I am referring to, let me bring you up to speed. GameStop, the video game retailer who’s essentially turning obsolete, was the subject of short selling. Short selling is an investment strategy that speculates on the decline in another stock’s price. Investors borrow stock from a broker and sell it immediately at its current price. They then wait for the prices of the same stock to decline, buy them back at a lower price, give the owners their shares, and pocket the profit.
This is my attempt at bringing this concept closer home. Let us say Pub Cookies was made by a company by the same name. I want to short Pub Cookies which has a current price of $5 per share because I speculate that students no longer want Pub Cookies and instead prefer healthier options (I know this is blasphemous). I borrow one share and sell it immediately on the stock market at $5. Soon, Pub Cookies are sold for a quarter because my speculation was right, and the share price drops to $3. I decide to repurchase (‘cover’) my short position and buy 1 share at $3 and return the borrowed share to the original owner. I made $5 when I sold the share and only had to pay $3 to buy it back lower, so my profit is the $2 difference.
But now let’s say that I was wrong in my speculation and that instead, because of Valentine’s approaching, more Pub Cookies are purchased. A Pub Cookies share goes up to $10. I still need to return the share that I borrowed, except now it is going to cost me a lot more to buy it back. If I buy it back at $10 so I can return the borrowed share, my loss will be the $5 difference between selling at $5 and repurchasing at $10. Since the price can rise indefinitely, my potential losses as a short seller are unlimited. This is the reason it is recognized that shorting is an advanced investment strategy that should only be undertaken by experienced traders and investors. Or so we thought.
A few weeks ago, a Redditor on r/wallstreetbets noticed that a hedge fund had taken a massive amount of short trades against GameStop. They convinced everyone on the thread to join forces and buy as much GameStop stock as possible. This made the share price rise to ridiculous amounts and the hedge fund’s short position started to lose billions. Their losses even surpassed the 13.1 billion that the hedge fund was worth. Eventually, the hedge fund had to close their short positions and buy all the GameStop stock back at much higher prices, sending the price even higher still. This is called a ‘short squeeze’. The hedge fund declared bankruptcy, and the Reddit thread was combing through other hedge funds with massive short exposure so that they could short squeeze them as well.
Curious about what implications this had for the United States Economy and Wall Street, I reached out to Professor Gasper Sekelj, an Instructor of Economics and Finance Studies at the David D. Reh School of Business:
“The bigger picture implication on what happened last week in the US stock market is the shift in perception of market power. It has long been perceived that market power resides with institutional investors such as mutual funds, hedge funds. Institutional investors typically account for most of the daily trading volume and they are typically perceived as more sophisticated and savvier than an average investor. The scheme employed was very sophisticated and savvy. Furthermore, if mobilized small investors can have an impact on the market. The action was almost celebrated due to the perception that the ‘little guy was taking on the big guy’. However, an institutional investor is a company or an organization that invests money on behalf of clients and or members. For example, small investors buy into mutual funds. As such ultimately some small investors were ultimately hurt, and a very small group of people actually greatly benefitted from the scheme.”
The David vs Goliath narrative is one adored by the American audience and last week’s demise on Wall Street would be seen no different. Robinhood, a stock trading platform put itself in the crosshairs by halting the trading of GameStop shares to plug the leak. Since the incident last week, politicians on both sides of the aisle have been critical of Robinhood and called for greater regulation and equality in the markets. Should there be regulations? “This is an interesting question,” says Sekelj. “I disagreed with the temporary suspension of trading GME stock by platforms such as Robinhood. The question that arises is: Did Robinhood have a conflict of interest in their action. However, I would not want to jump to a conclusion, a careful study of the situation is warranted. I would not like to see a ‘knee jerk’ reaction by regulators that might lead to future issues.”
So, what are the key takeaways students should have from last week, especially those interested in the field of Economics, Business, and Finance? Professor Sekelj responds, “The position that institutional investors took in companies like GameStop (GME) fundamentally makes sense. GameStop’s ability to generate future returns looks bleak as such a bet that the stock price will decrease (short sale) makes sense. Naturally, if you increase the number of buyers in the market the demand will increase, and as such the price of an asset in this case GME stock increase. Institutional investors must cover their short positions to minimize losses (they have to return the borrowed stock they sold in an equal number of stocks they borrowed). The action increases the demand for the stock even further increasing the price of the stock even further. However, after the short positions are covered the demand for the stock will start to decrease putting downward pressure on the stock price. Also, investors who want to realize their gains will sell the stock increasing the supply which also drives the price down. The students can see the principles they are learning in classes in action.”