The pandemic has increased the popularity of investing platforms such as Robinhood and ETrade as conversations around individual investing have been on the rise. At the same time, many already declining companies have suffered greater losses over the past few months. These two trends came together at the end of January when members of the subreddit WallStreetBets forced a short squeeze in GameStop stock (GME), causing huge losses for hedge funds while creating the opportunity for individual investors to gain unprecedented profits.
“Shorting” a stock is a term used to describe the practice of sellers making money off of their prediction that the price of a stock will go down. Short sellers will borrow shares of a stock from a broker and then sell the borrowed stock to investors at that price. When the price of the stock goes down, they buy the number of shares they borrowed from investors and sell those shares back to a broker. Because the price of the stock has decreased, they make money off of the difference in price between when they borrowed the shares of the stock and then sold them back to the broker. The practice of shorting is risky for individual investors but works for advanced investors.
A short squeeze occurs when the price of a shorted stock is driven up. Short sellers are then forced to buy the stock in order to protect themselves from greater future losses in case the price of the stock keeps rising. Their buys also simultaneously raise the price of the stock. In the case of GME, Redditors in the WallStreetBets subreddit bought shares of GME, driving the price of the stock up. When the short squeezing started, the stock shot up from just around $17 to an intraday peak of $483. This is why major hedge funds lost billions of dollars during this time. For example, Maplelane Capital reported a 45% loss while Melvin Capital Management had a 53% loss at the end of January.
While wealthy hedge funds lost billions, ordinary citizens were making major profits, the likes of which they have never seen and probably never would have if it hadn’t been for this. Many Reddit users shared that they were able to pay off student, car and home loans, with one Redditor showing a screenshot of them paying off all of their $23,000 of student loans at once. Many users also shared how their own families were affected by the 2008 financial crisis, and short squeezing GME was seen by many as a sort of revenge for Wall Street’s greed. These success stories from ordinary people reveal the power that individuals have in uniting against what many see as impenetrable systems in Wall Street’s game.
As a result of this, it is likely that hedge fund managers will be more cautious about shorting stocks in the future. However, this is not necessarily a good thing. Research shows that shorting helps balance out and maintain a healthy overall market. Short sellers’ practices usually offset stocks that are overvalued, helping to identify companies with fraudulent practices. While what happened to GME stock definitely helped many individuals make money, it is important to remember that at the end of the day, the price of such stocks will inevitably fall. The bubbles will pop, and when they do, many ordinary investors who hopped on to the trend will be left with shares of a weak, declining company’s stock.