GameStop Corp. (GME) made headlines last week after a wild week in the stock market.
Shares rose 1,625% in the month of January to $325 per share. That parabolic rise intensified last week and hurt hedge funds like Melvin Capital, who had a large short position on GME.
Melvin lost 53% in January on their shorts, accounting for about $6.6 billion in losses. When an investor shorts a stock, they borrow it from someone else, immediately sell it, and wait to buy it back to return the borrowed shares later. The shorting investor earns a profit when the stock price falls, and loses when the price rises.
On Jan. 26, GameStop’s shares were traded more than the S&P 500. By the 28th, brokerage firms like Robinhood, ETrade, and others stopped users from buying GameStop.
Individual investors who used the Reddit channel “r/WallStreetBets” cried foul play from the financial institutions, leading to a class action lawsuit against Robinhood. Additionally, politicians like Alexandria Ocasio-Cortez, D‑N.Y., and Ted Cruz, R‑TX., joined the call against brokerages restricting selling.
Associate Professor of Finance Robert Atra said he doesn’t see last week’s volatility in quite the same way. In class on Friday, Atra pointed to traditional financial metrics like the short ratio to explain that GameStop was experiencing more shorting than can be possibly sold.
The short ratio is the ratio between the number of shares in a company sold short over the average daily volume of the stock. On Jan. 15, that ratio was 2.81, which was 226% of shares available for trading.
“The way it’s written is like pitting one group against the other,” Atra said. “I don’t think that’s the case. I think it was just following a traditional signal that something was oversold, and because it was short sold the shortsellers had to buy it back and the people taking long positions ended up benefiting from shortsellers buying it back.”
Considering this short pressure, which requires firms to buy the stock to close their position, hedge funds were required to buy back into GameStock as the price ticked higher, and that further sent the stock upward.
“When something is that heavily shorted, it doesn’t take a lot of movement to cause massive buy-ins,” Atra said.
This is what’s known as a short squeeze, and it’s exactly what happened last week with GameStop.
Practitioners have developed metrics for market conditions like this. Short sale indicators like the short ratio appear in textbooks like Donald E. Vaughn’s “Survey of Investments” from 1967.
GameStop is hardly the populist revolution in finance the WallStreetBets community may want it to be. Rather, the GameStop saga is a unique aberration in equity markets caused by a perfect storm of size, trading volume, and short selling pressure, according to Michael Burry, who first shorted the housing market in 2007 that later became featured in the book and movie “the Big Short.”
“There really can’t be another GME,” Burry said. “Nothing else is/was even close to as shorted and so hated/ignored/dismissed prior to the #thebigshortsqueeze.”
Nor is it a flashpoint of institutional backlash against the group of individual investors at odds with Wall Street traders. Robinhood CEO Vlad Tenev said the firm halted trading on certain equities to maintain its capital requirements.
“I always wondered about the Robinhood business model, myself,” Atra said. “It sounds like there was so much trading they couldn’t afford to do the trading.”
By Monday, Robinhood raised $3.4 billion to help facilitate the volume of trading users were demanding. If that’s the case, the curb on trading had to do with brokerage firms’ ability to clear trades more than with executing them.
With the restrictions eased, online investors have redoubled their efforts this week on GameStop and have since shifted buying pressure into silver. But in the end, experts in the field like Atra don’t see this flashpoint resulting in much beyond an episode of simple speculation.
“If you’re cheering on the populist investors, what do they do with GameStop now? Are they bailing out and taking their cash, or are they hanging in?” Atra said. “Surely those investors don’t think GameStop is a great long-term investment.
“Fundamentally, this has very little to do with long-term investing,” Atra said. “Nobody’s 401k should be really concerned with this kind of activity.”