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David beats Goliath: Retail investors cause hedge funds to lose billions of dollars for trying to short-sell Gamestop stock

Experts believe that internet activity caused driving up Gamestop's stock prices as retail investors are putting their money in such new stocks, who are otherwise locked out of lucrative opportunities such as initial public stock offerings by the big hedge fund investors.

The skyrocketing of the stock price of GameStop, a video game retailer, has been a taking point in Wall Street. The retail investors, fuelled by social media rumours, have taken up the gaming seller’s share price to the top, leaving hedge fund managers and big investors in a bit of a fix.

According to the reports, GameStop surged 50 per cent in extended trade session after Elon Musk took to Twitter to tweet, “Gamestonk!!” and also posted a link to Reddit’s stock trading discussion group, where social media users refer to him as “Papa Musk.”

Apparently, “Stonks” is a tongue-in-cheek term for stocks widely used on social media.

The stock price of ‘Gamestop’ reportedly rose nearly 8,000 per cent over six months. The stock has now become the point of a financial power struggle between a major hedge fund, Melvin Capital, and a group of retail stock traders. The sudden rise in the share price has left hedge funds in a tough position, forcing them to buy GameStop shares to cover their position and driving the price still higher.

What really happened

The Gamestop stock was targeted by a group of retail investors, who are members of a reddit group that targets hedge funds doing short selling. When the share price goes up, those who taking short position in that stock loses money. In short selling, traders make money when the stock price goes down. Here is how it works: the investor borrows the share from a broker, against a small fee, and sells the share in the current market price. Later when the share price goes down, the investor buys the share again, and returns in to the broker. Now since the share was bought at a lesser price then the initial selling price, the difference between the both is the profit made by the investor.

Lets see it with an example, say share ABC is trading at Rs100, and an investment firm believes the price will go down. So it borrows a share from a broker, and sells in the market, getting Rs 100 as the price. But the firm has to return the share to the broker, as it was borrowed. Now later, if the prediction is correct and the price indeed goes down, to say Rs 80, it buys the share at that price, and returns the same to the broker, thereby making a gain of Rs 20.

If the opposite happens, the share price goes, the investor losses money. The investor can wait for it to come down, but it has to keep paying the borrowing fee for the stock. Moreover, a share price can keep going up infinitely, and the investor has to settle its position at some time. Most of the time they chose to buy the share at higher price to return, making a loss, to prevent higher loss if the price rises even more.

This is exactly what happened with the stock. Hedge funds that do short-selling take larges positions in shares hoping to make quick gain. When retail investors noted that such funds have taken short positions on the Gamestop stock, they started an online campaign to buy the share to drive its price, to ‘punish’ the hedge funds. Although initially, the stock price of the company had increased due to organic reason, after the company had added three new directors to its board, including Chewy co-founder Ryan Cohen. Investors liked that a person with digital experience was joining the board, and the positive outlook caused the share to rise.

However, investors estimated that the company’s stock will go downwards, as the retail price is expected to remain sluggish in the following year due to the Coronavirus pandemic. Last week, Citron Research placed a bet against GameStop calling it a “failing mall-based retailer”, and predicted its shares would fall to $20 because it is “pretty much in terminal decline”.

As a result, hedge funds took a short position on the stock, hoping to make money when the price tanks. However, retail investors, organised via Wallstreetbets, a trading subreddit, had other ideas, and they declared war on the short-sellers. Eventually, they were successful in driving the stock price up by large scale coordinated buying, with the share reaching around $350.

This caused panic among the short-sellers, who were forced to buy shares now to cover their position, as their losses continue to rise with the rising share price. This buying by the hedge funds have further caused the share price to increase.

Melvin Capital Management, on of the firms that stood to gain if the share price of Gamestop drops, took a huge loss to close its position in the stock. The company has lost around 30% of the $12.5 billion fund that it manages this year.

The organised effort got another boost after the Musk tweet, who hates short-sellers as they had tried bring Tesla shared down several times in the past. As the shares are used a collateral to raise funds, when a company’s share price goes down, its capability to raise fund is impacted, hampering its financial position.

Game stock price surge after retail investment surges

GameStop’s surged to a 93 per cent jump on Tuesday’s trading session alone. Experts believe that internet activity caused driving up Gamestop’s stock prices as retail investors are putting their money in such new stocks, who are otherwise locked out of lucrative opportunities such as initial public stock offerings by the big hedge fund investors.

Influential Bloomberg columnist Matt Levine said that “GameStop is just a game” and assessing its stock value is pointless as “it has all the prices at once.” Meanwhile, the GameStop boosters on Reddit are celebrating their victory over the Wall Street establishment. They pointed out the misery of the hedge fund managers while highlighting the irony of Wall Street majors getting beaten by a ‘pack of Reddit yahoos’.

The share spikes of the last few days have also questions about potential regulatory clampdowns from the US Securities and Exchange Commission.

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Staff reporter at OpIndia

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