Q&A: A basic guide to the GameStop squeeze (2024)

Financial markets have been thrown into turmoil by retail investors using social media chat groups such as Reddit and low-cost investment platforms to drive up shares in GameStop, a US video game retailer. The phenomenon has spread around the world, including to the UK, where Pearson, Cineworld and Hammerson have been among targeted stocks. In what is called a “short squeeze”, the share buyers are putting intense pressure on hedge funds and other institutional investors, who bet that these equities would fall.

What is a short squeeze?
In order to “short” a stock — to bet on its decline — an investor borrows shares from a broker and sells them. If the stock drops, the investor can buy the shares back, return them and lock in a profit. But if the shares go up, they have to “buy to cover” before their losses mount. If a heavily shorted stock rises quickly, mass short covering ensures, driving the stock up still further, forcing more short covering and still further price appreciation, until all the shorts are forced out. This happens with some frequency.

Is that all that is going on with GameStop shares?
No. First of all, not all the shorts are being forced out — the proportion of GameStop shares that have been lent to short sellers has remained high. So as some shorts have been forced to sell, others have been happy to step in.

Gamestop’s price has been unusually high for several weeks now, suggesting that there is a strong element of plain old speculative frenzy here, that is, the phenomenon wherein investors believe, wrongly, that an asset “can only go higher”.

The Gamestop rally is also a “gamma squeeze”. Many investors are betting on GameStop — and other formerly unpopular stocks such as Nokia and AMC Entertainment — by using call options: contracts to buy a stock at a certain price in the future. When a broker sells a call option, they buy a certain number of shares of the underlying stock to hedge their exposure and make sure they can make good on the contract when it comes due. The amount of shares the brokers buy increases with the stock price. This buying-to-hedge can force the share price up further, forcing more buying to hedge, and so on.

Why did Robinhood, and other brokers, decide to block or restrict buying of Gamestop?
Hard to say for sure. Robinhood must have had a compelling reason, because the move infuriated its core customers and has already led to lawsuits.

In a statement on Thursday, the company said: “As a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearing house deposits.”

This refers to the fact that when a brokerage accepts a trade, it must post cash (“margin”) with the central trade clearing house until the trade is settled, with the buyer and seller delivering the cash and the shares, respectively. The margin is there to cover the losses should one party or the other fail to make good on their trade.

The amount of margin goes up when the volume and volatility go up. At the same time, brokers are required to have a certain amount of cash on hand at all times, and this varies with activity, too. So it looks like Robinhood simply didn’t have enough money to keep taking “buy” orders. This is consistent with the fact that the company raised new funding on Thursday.

The GameStop ‘short squeeze’

Q&A: A basic guide to the GameStop squeeze (1)

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This may not be the whole story, though. When a broker accepts trades, especially options trades, it is taking risk. It may be that Robinhood thought it was taking so much risk on GameStop trades that it was in existential danger, and so it decided it had to do something, anything, to cut down the trading flow.

Is the US government stepping in?
Not so far, but it is making concerned noises. The US Securities and Exchange Commission says it is “working with our fellow regulators to assess the situation”, and there are reports that it is considering a market manipulation case. Senator Elizabeth Warren, a famous scourge of the finance industry, says: “It’s long past time for the SEC and other financial regulators to wake up and do their jobs.” But it is far from clear what regulators and politicians should or could do.

Is any of this illegal?
Possibly, but it would be very hard to prosecute. Most prosecutions for fraud or market manipulation hinge on deception, and it is not clear who has been deceived here.

The Exchange Act of 1930 says it is against the law for anyone to “to induce the purchase or sale of any security . . . by the circulation or dissemination . . . of information to the effect that the price of any such security will or is likely to rise or fall because of market operations of any one or more persons conducted for the purpose of raising or depressing the price of such security”.

In English: you can’t tell people to buy or sell on the grounds that you and your friends are going to do things in the market with the explicit purpose of pushing the stock up or down. It doesn’t have to be deceptive to be illegal manipulation.

The people on the Reddit message boards have, in effect, shouted out their intent to drive up the prices of certain stocks, for no other purpose than driving them up and driving out the short sellers. That seems to be against the letter of the law, but the government has not prosecuted this sort of thing in the past. Notably, they sat on their hands when big market players turned the market against one another, as when, a few years ago, Carl Icahn squeezed Bill Ackman out of his short on Herbalife. And are the funds that heavily shorted GameStop not manipulators, too?But aggressive shorting has long been condoned by regulators.

Is this a new phenomenon?
Not really. It is classic late-cycle speculative excess, like the tulip, dotcom, and housing bubbles, but this time it is supported by the emergence of low-cost trading and new communication platforms. But it is possible that retail trading will play a bigger part in markets in the future because of these developments.

Will this end badly?
Definitely. GameStop shares are probably worth less than $10, based on the company’s fundamentals. That fact will assert itself eventually, whatever anyone does, and someone will lose a lot of money. It’s been a zero-sum game all along.

Q&A: A basic guide to the GameStop squeeze (2024)
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