Hedge funds, Reddit, and GameStop: An unprecedented time in global finance with billions on the line
Updated: Feb 3, 2021
The avatar character associated with the Wallstreetbets subreddit, an online community that's making waves in the global financial market and, according to some, beating the hedge funds at their own game.
Editorial by Seth Dukes
If you’ve had your television on at least once in the last four days, you’ve likely heard about what a community on the internet called Wallstreetbets is doing to the stock market. However, for those out of the loop, it can be a difficult concept to grasp from a 30-second news brief. What is happening is unprecedented, and it’s something that everyone ought to somewhat understand for history’s sake. As someone who has been following the story since it began, I thought it might be helpful if I explained what is going on, how it happened, and what I think the result could be.
Let’s start with the stock that’s driving everyone wild: GameStop (which I’ll be referring to henceforth as GME). GME is a company that sells video games, consoles, and video game memorabilia. They have not done well in recent years as their stores are struggling to compete in an environment of online game sales and digital downloads. The price of GME stock dropped to around $3 per share back in April of 2020.
Wallstreetbets, which is a community on Reddit that discusses highly speculative stock predictions, noticed that investors were betting against GME. Investors decided to short sell the stock, which is essentially like gambling for investors. Short selling is a trading strategy that speculates on the decline in a stock’s price. Investors believe that the price per share will go down due to GME failing, so they’re expecting to make a nice profit while GME loses even more money.
If you’re unfamiliar with what “short selling” is, here’s an analogy that will make it easy to understand. Your friend has a record collection full of unpopular bands. You tell your friend that you will pay them $0.05 per day if they let you borrow the collection for a few months, and they agree. You take the collection to a pawn shop and sell it for $100, predicting that no one else will want it because the bands aren't popular and, in a few months, you’ll be able to return and buy it for a discount. You are right! No one wants the collection, and you return in three months and purchase it for $60. You return the collection to your friend, and you profit whatever the difference is between your interest payment to your friend and what you sold the collection for. Imagine doing this hundreds of thousands of times, and that’s essentially what the hedge funds were doing with GME stock.
Now imagine that people in the community find out that you’re betting against the bands in the collection. Imagine they grew up listening to those bands and they have a strong connection to them. They decide to go to the pawn shop before you and buy the collection for $150. Now you’re in trouble. Not only are you paying your friend $0.05 per day that they don’t have their collection, but you’re going to have to pay more than you sold it for in order to replace it and stop paying interest.
That’s what the Wallstreetbets community did. They bought GME shares shorted by investors in droves, causing the price to skyrocket up to above $300 per share. What’s more, they refuse to sell the shares they buy, putting immense pressure on the hedge funds. Returning to our record collection analogy, imagine if the people in the community that bought the collection refused to sell it for anything less than $3,000. You're forced to either take a huge loss immediately to fulfill the contract with your friend, or wait for them to drop their asking price while you're bleeding money in interest payments all the while – a lose-lose situation. That could be the position that hedge funds are eventually in.
So, what does this mean for the market as a whole? Well, many large investors are liquidating positions in long-term investments, presumably to increase capital so they can purchase the GME stocks and fulfill their contracts. One hedge fund, Greylock Capital, filed for bankruptcy on Monday. But the truth is we’re just going to have to wait and see what happens. My own personal prediction is that they will eat some loss in order to drag the situation out a few weeks in hopes that the movement either loses traction or retail investors grow tired of having their capital tied up in a stagnant position. However, as someone who has been a part of Reddit since 2009, I think they underestimate just how stubborn some of us can be.
The poster child for the movement, a Reddit user with the screen name DeepF***ingValue, holds approximately 55,000 shares of GME. As of Jan. 27, the GME stocks that he owns are worth $16.5 million, and that’s with GME stock prices at about $300. Imagine if those shares were worth $1,000 each.
There’s a lot of controversy surrounding the situation, including Robinhood, one of the top-rated investing applications, limiting the amount of GME shares that retail investors could purchase at the end of last week. This drew criticism from some as they insisted that the move was made in order to protect the hedge funds’ profits at the cost of the retail investors. Some retail investors are also alleging that the hedge funds shorted more stocks than were in circulation.
I’ll definitely be keeping up with how things play out. I purchased two shares of GME so that I could say I was a part of this in 50 years when I’m telling my grandchildren about it. I could very well lose my entire investment, which I am prepared to do. You absolutely should not consider anything in this piece financial advice; it is purely for educational purposes. If you feel comfortable paying $250 for a ticket to a ride, however, then I think this one is well worth the cost of entry.