How Reddit fueled a stock market surge
It’s a tale tailor-made for a digital era. A gleeful army of amateur investors last week took on Wall Street hedge funds that had bet against video game retailer GameStop and, at least briefly, beat them at their own game.The stock fell back to Earth this week and many retail investors are accusing major hedge funds and brokerage services of market manipulation. The David vs Goliath story dominated social media and drew international attention. UNI finance professor Zhongdon “Ronnie” Chen, who studies how the attention of retail investors affects market fluctuations, shared his insight on the extraordinary events with InsideUNI.
But, first, a quick explainer on the situation. What does it mean when an investor “shorts” a stock? Basically, they’re betting that the value of the stock will decline. They borrow shares and sell them at market price, gambling that when they have to buy the stock back to return, they will have dropped in value, returning a profit. In the GameStop case, investors shorted 140% of the company’s shares, meaning there were more short positions than available stock. Investors noticed this trend and started what’s called a “short squeeze.” This is when they buy as many shares as they can, which raises the price of the stock and forces the short sellers to buy the stock to mitigate their losses. This rapid, mass-purchase of the stock would theoretically cause the price to briefly skyrocket.
People and companies have been shorting stocks for decades, what was different this time?
In many ways, it was because of technology and social media. Before, it was almost impossible for retail investors to come together and organize anything. But today, with Facebook, Reddit and forums online, it's easier for people to organize a short squeeze.
GameStop was surging late last week, and then Robinhood, the popular brokerage app, restricted its users from buying more stock, which caused the share price to plummet. The move infuriated retail investors. Why did Robinhood make that move?
I have been using Robinhood for probably five years, I received an email from Robinhood, explaining why they didn't allow people to purchase any more shares of GameStop, AMC and other heavily shorted companies. They say it's because of clearinghouse deposit requirements. According to their words, if their customers are holding volatile stocks, they need to make a bigger deposit. They implied that, at that time, they didn't have enough liquidity to meet the higher deposit requirements. And that's why they limited the number of shares investors can purchase. But I don't believe that. Robinhood is probably holding a lot of very liquid financial assets. So if they really need liquidity, they can just sell those liquid financial assets to raise capital. So I think that might be just an excuse.
Some people have taken the lesson and taken from this is that the stock market isn't reality. It's completely divorced from anything that's meaningful, and it's just different groups trying to game each other or game the market? Is that an accurate analysis?
I have to say what we have experienced is one perfect example of a free market. We have financial instruments, including the stocks, in the financial market. And we have people trading those financial instruments. So, there are actually two parts, the instruments and people trading those instruments. Yes institutional investors can short as many shares as they want, it is legal. And the retail investors can purchase as many shares as they want too, which is also legal. It's just a free market.
I think the short squeeze on Gamestop is a result of many factors such as lower transaction costs for retail investors, extremely high short ratio on Gamestop, ease of trade for retail investors, social media and the change in top management at Gamestop, which gave retail investors some hope on the company.
People have said that this is sort of a victory for the small person and will revolutionize trading. Do you agree with that?
I think it really depends on what perspective you're looking at. In the very short term, it is a big victory for some retail investors. Obviously, people who got in early made a lot of money. I saw one tweet where somebody purchased $50,000 in call options on GameStop and in a couple weeks, that turned into around $11 million. That’s what fueled this. The other investors thought they would make money off this thing so everyone flooded into GameStop. That’s the power of social media. But, I think eventually the share price will go down. Because, eventually, everything will return to its true value. There are so many retail investors and those investors will eventually get scared off and take the profits, pushing down the price. The most important thing is it’s going to change how institutional investors short stocks. Citron, one of the institutional investors that shorted Gamestop said they wouldn’t short anymore and would invest on the long side. One of the reasons why retail investors were so angry with the institutional investors who shorted is because every time the price would rise, the institutional investors would say, “I don’t think the value’s there,” and they would continue to short the shares, which would drive down the price of the stock.
Will there be any changes to how hedge funds short companies after this episode?
I think there might be more regulations regarding shorting in the future. To me, it doesn't make sense to short a company 1.4 times. I also think there might be regulations regarding how trading platforms can limit the behavior of their retail investors, like when Robinhood said, “No, you cannot purchase anymore.” Robinhood doesn't have that power, the SEC has that power. And that's why the SEC is looking into this. Based on what I've read in the news, so far, the government seems to be on the retail investor side. Overall, I think a lot of people will get regulated in the future.
What do you think the impact of this will be in the future? Is this something people will look back on in, in five years and talk about or is this sort of just another kind of blip that will be forgotten about?
Certainly, we’ll have more people interested in investing and trading stocks, and maybe the demand for a finance major, or business major would increase. Second, I think people are going to see retail investors in a completely different way. Soon, they might have a bigger role in the financial market. As of now, the major players in the financial market are still institutional investors, such hedge funds, mutual funds or retirement funds. They are probably 70%-80% of the entire stock market. And now retail investors are getting in. Maybe people will start buying a lot of mutual funds, or maybe they like to manage their own funds. It is also possible that, after everybody has had a taste of trading stocks and having losses, they'll be less interested in trading stocks. We don't know. Opportunities like GameStop are unique. The sure thing is that Gamestop won’t be the last company to experience a short squeeze. But I don't think we're going to see another one of this magnitude anytime soon. Because the Gamestop short squeeze was a perfect storm where many random variables came together. I think it will be difficult for retail investors to recreate something similar.