GameStop Saga: The Long & Short of It
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A friend asked me what my view around the GameStop saga was, and honestly, I didn’t have much to say at all. It is all a bit of a yawn to me.
The market seemed to behave as I would expect, and so did most of the players.
Unfortunately, the entire saga has become a magnet for everyone’s personal cultural trope. GameStop was an example of <fill in the blank>
I have seen segments on TV where an entire five-minute clip is full of absolute BS. I mean 100% BS. Why are they interviewing economists about what happened here? They have no clue about anything, least of all about the stock market.
I do not want to add to that noise. I don’t think I can.
But I can explain some of the basic mechanics of trading, which I hope will be illuminating and provide a basis for when (not if!) this happens again.
Let’s start with investing basics.
If you like a company, you think it is going to do well. When I say well, I mean you think it is going to continue to make profit forever. You might decide that you want a part of that success and buy some of its stock.
You buy those stocks through a broker. You can’t buy them at a supermarket, local farmers market, nor purchase it off Amazon. You need a broker that has access to the stock market and clearinghouse. I will get to the latter two again later in this article.
In theory, the company can sell directly to you. Sometimes they do this through employee benefits. But we are focusing on the majority (not employees) for the moment.
In Wall Street parlance, to buy something is to go LONG. Going long is part of the vernacular in the inner circle of Wall Street. You can say you are going LONG something you like, want, or have really bought into.
You are going long this weekend; maybe you are long sunshine or long a relationship.
LONG also means to have bought or to own something, like a stock.
So, what is selling? Selling is to go SHORT.
Again, this also spills into common language for Wall Street finance types. To short something is not to want it or to expect it to be harmful to own.
You could be short your job, short the (bad) weather, and indeed, you could be short a relationship.
Make sense?
If you are shorting, you are selling. If you are going long, you are buying.
When I first entered Wall Street, this difference was one of the hardest things to get my head around. So, if you struggle, don’t worry; I did too.
Why would someone want to buy (go long) or sell (short) GameStop?
First of all, what is GameStop?
These guys operate a bunch of consumer electronics and collectibles stores in the United States, Canada, Australia, and Europe. Think EB Games.
In fact, keep thinking about EB Games. Because GameStop owns EB Games.
A quick review of their financials tells me that GameStop made about $6.5billion in revenue last year (2020).
Not too shabby, hey?!
But before you call your broker and go LONG some GameStop shares because you like EB Games, we should dig a little deeper.
One should also look at how that revenue is turned into earnings (or profit)—the reason companies exist.
And this is where the story becomes a bit more glum. Earnings for 2020 were down nearly half a billion. What is more, its revenue was down from $8.29 billion in 2019.
$8.29 billion down to $6.5 billion feels, to me, like the company is losing some significant traction.
With declining revenues and earnings, Wall Street will have some very close eyes on you.
It turns out there are several other factors that can be added to the negative story for GameStop. Declining revenues and earnings do not happen in a vacuum.
Considering these factors, the Wall Street elite’s feeling is that Gamestop will soon come to a complete halt.
Now, do you think that Wall Street will sit by and let a company go bust without trying to make money from it?
No; Wall Street makes money out of everything.
Trading Mechanics
First, let’s look at the nuts and bolts of trading—the mechanics.
We can all agree that when you buy 100 shares of a stock (go LONG 100 shares of stock), and the price goes up, you have made money.
Let’s do some simple sums.
You own 100 shares of a stock worth $50.
The price of that stock goes from $50 to $100. How much have you made?
Well now you own 100 shares of a company worth $100 per share. Therefore, the shares are now worth 100x$100 = $10,000.
But you paid, 100x$50 = $5,000.
You’ve made $5,000. Nice.
But what happens if you think the price will go down?
If you think the company is not worth what it is currently trading for, you sell this same stock, right?
Correct.
How much do you gain from selling your 100 shares and then the price goes down? Nothing.
Why? Because you don’t own the shares anymore.
You have gone from 100 shares owned, to owning 0 shares.
You have avoided a loss, which is always a good thing.
But can we also make money from a company stock price falling?
The simple answer is yes; you can sell short.
What is selling short?
Selling short is more than selling stocks that you own because you think it might go down.
When you sell short, you borrow shares, usually from a broker, and then sell those shares as soon as you get them.
When the price goes down, you buy back the shares at the lower price, and then hand them back the stock to the broker. You only borrowed it after all.
Here’s the math.
You borrow 100 shares in a stock from a broker at $50 per share and immediately sell those same shares into the stock market for $50 per share. That’s $5000.
But you still have to return your borrowed shares.
So, later that day, week or month, the share price drops to $10, and you repurchase them for $1000.
You have made the difference between $50 (what you sold them for) and $10 (what you repurchased them and returned for), which is $40 per share. In this example, you’ve made $4000.
Not bad.
The thing that Wall Street likes about selling short is that being a profitable and successful company is difficult.
Capitalism, it turns out, is tough.
GameStop was on many watch lists for bankruptcy—see this report by Kiplinger of 10 retailers likely to file for bankruptcy. Number 10 is Gamestop.
It is relatively easy to see a company that is in trouble. And when you see a company that’s in deep trouble, you sell short, because you can make money as the company loses money.
What’s the problem with selling short, and why don’t more people do it?
The problem is that the maximum amount of profit you can make from selling short is the price you paid to borrow the stock in the first place.
So, if you borrowed and sold at $50, the most you can make is $50 per share. Why?
Because stocks can become worthless (or worth $0), but a stock can never be MORE than worthless.
On the other hand, a stock can double, triple, or go up 10fold.
There is, in other words, a floor ($0), but no ceiling (infinity $).
If you’re selling short, and for some reason that stock price goes up and up, you might find you are losing a lot more than you paid to borrow the stock.
But it gets worse. Here comes the short squeeze.
Imagine you borrowed and sold GameStop shares for $50 and then it goes to $60. What do you do? You have lost $10 per share. Ok, it might make you nervous. Probably pretty blood nervous. But you might decide to hold on for now. After all, GameStop is probably going to file for bankruptcy.
But then that same stock goes to $100. Now it’s an entirely different story; you are in serious (and I mean serious) trouble.
How do you stop this pain? Well, this is the crazy part.
When you are long a stock (own it) that is going down in value, you stop the pain by selling your stock.
But when you are short selling a stock, you stop the pain by BUYING the stock.
You must BUY the stock back in the market, adding to the upward price pressure that has been killing you in the first place. Plus, ALL the short-sellers know you will do this.
They know they are being chased, and every time a short seller folds, that ADDS to the amount of buying, which then adds to the positive price pressure.
It’s a positive feedback loop—think of it as a market crash but in reverse. But for the short-sellers, it’s a positive feedback loop from hell.
But for those that are long or own the stock? It is nothing short of euphoric; they’re the ones making all the money.
Why did the people on r/WallStreetBets identify GameStop as the target to start buying?
Because GameStop had over 130% of its stock sold short. Keep in mind that a typical short interest sits around 4% of the open interest (available stock).
How do you sell short more shares than are actually in existence?
In many instances, the same group (or lot) of shares get borrowed and sold multiple times. The person buying these shares doesn’t know if they were borrowed or owned in the first place.
So, a company having more than 130% short is both possible and legal. It’s beyond the scope of this article to flesh this out in detail. I will do this at a later date…but suffice to say, many parties were betting on the destruction of GameStop.
They just hadn’t anticipated a group of savvy and coordinated Reddit users.
This has happened to me.
I have been on the right side of this equation myself before.
I owned a stock that I had bought heavily in the early to mid-’90s, that got caught up in a short squeeze. The company was Qualcomm.
But I was long, and I had been for quite a while before it was gaining any real attention.
Qualcomm owns the technology and intellectual property for much of the plumbing that is essential for smartphones. This being a success story seems super obvious now, but back then, people were not so sure. Then, in one year, the stock price went up 20-fold; most of which occurred during one trading session.
It is difficult to describe the euphoria when this happens. It’s kind of overwhelming. You start feeling like you are the master of the universe. Being right is one thing. Being right and rewarded with a load of money is an entirely different level.
Luckily, I was experienced enough that it did not go to my head. I had already had the antidote for this delusion—losing loads of money just as quickly.
However, our friends on Reddit’s WallStreetBets will feel like gods after they made millions in one day.
Robinhood and hedge fund conspiracies
The short squeeze happened on Wednesday and the very next day, the online broker firm, through which much of these transactions took place, Robinhood, instituted a trading holt to various companies, including, you guessed it, GameStop.
So, do I believe that hedge funds conspired with Robinhood to halt trading to screw the little guy?
No, I don’t.
Let me explain.
After you sell your stock at a brokerage firm, you will notice that your cash is not immediately available to withdrawal.
Why can’t you have your cash immediately?
Well, let’s talk about who is involved with a stock selling transaction.
As mentioned earlier, to trade a stock, you need a broker. And the broker requires a stock market and a clearinghouse. Told you I would get back to it.
What’s a clearing house?
When a buy (or sell) order goes to the stock market, there is an exchange with a buyer and a seller. Someone wants the stock you are selling, or vice versa. Once this has been agreed and exchanged on the trading floor, this transaction is sent to a clearinghouse, called the Depository Trust & Clearing Corporation or DTCC.
The DTCC is enormously important; they keep track of all brokers’ books and, more importantly, guarantee that the transaction will take place. The DTCC remove the risk of a broker going bankrupt while holding onto transactions.
Clearinghouses remove systemic risk. In a post-GFC world, this is vital.
The DTCC guarantee settlement.
When does settlement happen?
It happens on T+2—an entire two days later. By settlement date, the broker for the seller must deliver the stock being sold, and the buyer’s broker must provide the cash.
But that is two entire days of risk. Anything can happen with the stock and the cash within that time frame.
Especially, and this is the crucial part, if the stock is moving rapidly from minute to minute. Where could it conceivably be in 2 days? Can the brokers make good on their transaction?
There is, in other words, risk for the DTCC. Because, thankfully, the DTCC has already guaranteed the transaction for the buyer and seller.
How can the DTCC do such a thing? Are they just very rich and benevolent financial intermediaries happy to ensure our financial system’s smooth running?
Of course not.
They require collateral. Collateral from ALL brokers, including Robinhood, for all the stocks being transacted.
Think of collateral as an amount of money deposited with the DTCC to ensure the transaction will take place and cover potential shortfalls. Like a deposit on a house, it ensures that everyone is serious, and covers for some potential downside should the worst happen.
This is where Robinhood got caught out.
What determines the amount of collateral required and what did that mean for Robinhood?
It is a relatively complex calculation that is different for different stocks.
For highly liquid (highly transacted) stocks, it is probably around 10% of the transaction value.
But for stocks that move big time, as GameStop did, the amount of collateral required goes up big time. Adding to this, when the transactions are made on margin (when an investor buys by borrowing money), the broker needs to come up with the cash as well.
Robinhood would have had to suddenly pony-up billions (my guess) of $$ to ensure the continual operation with the DTCC—money they wouldn’t have had at the time.
So, Robinhood had to restrict buying and not selling, which caused a big stir amongst journalists and economists who know utterly nothing because, from the outside, that looks terrible. But the reality is just down to market mechanics.
Why did Robinhood restrict buying and not selling of stocks?
The reason was simple—selling means the broker needs to place the shares, not cash, as collateral.
Buying requires cash. Robinhood had the shares, and not the cash.
So, rather ironically, Robinhood and the Reddit users were short squeezed as well.
So, who are the winners and losers out of this?
The winners are those you might not expect.
Anyone that had already owned GameStop shares before this event, and was wondering when to sell, just had an opportunity of a lifetime.
I suspect many of the senior managers of GameStop would be part of this cohort. I think there will be many, though highly concentrated in a few, from the Reddit site that will also have done very well.
Were the hedge funds the real losers?
This will take time to play out. But I suspect, that yes, some hedge funds got screwed that day. But they might already be recovering.
The other real losers will be the retail investors (non-professional investors) that think they have bought into a Bitcoin-level of stratospheric ever-increasing money. But this isn’t Bitcoin.
So, do I have a good idea of where this is headed?
You bet you I do, and this is knowledge that I share with my clients. Let me say, this saga has a few stages to play out, and it’s something you will want to keep an eye on.
If you would like professional advice regarding the GameStop saga, or any other investments, please contact me.
This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.
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