A true David and Goliath battle played out over the course of a couple of weeks in January.

A war was waged on the Hedge Fund Managers and other wealthy investors that had shorted the GameStop stock (a video game retailer) by an army of Redditors mobilised within the WallStreetBets subreddit.

What is WallStreetBets?

WallStreetBets is a subreddit –a sub-forum – on Reddit.com (the 18th most popular website), that brings people together to discuss stock and option trading.

A quick check of its “about” section shows that it describes itself as “4chan found on a Bloomberg Terminal”.

It typically promotes short term, highly speculative trades, which are more akin to gambling, as opposed to a long-term investment strategy.

Given it usually recommends taking a gamble on a stock, perhaps it is no surprise that a stock such as GameStop was touted as the next big thing.

Melvin Capital and 120% Short Float

So why was GameStop popular enough for this subreddit to reach international news outlets?

Well, Hedge Funds (and particularly Melvin Capital), had seen GameStop as the “next Blockbuster”, and began to short the stock, as they believed the price could only fall.

By shorting the stock, they are able to “borrow” it from a broker, and sell it immediately.

The reason they would do this, is that they believe the stock price will fall in the future.

Once it falls, they simply buy it back from the market at the lower price, and then take a profit of the difference between the two.

Redditors on WallStreetBets had noticed that the GameStop stock had a 120% short float, which means that there were more shares shorted than were actually available.

If they could get enough people to buy the stock, and hold, then there could be a theoretical short squeeze situation, as previously witnessed with the Volkswagen stock as Porsche started to buy up as many shares from the market as possible.

What is a Short Squeeze?

When an investor shorts a stock, they sell it to the market, and then buy it back later.

They need to borrow the share from a broker, who requires the investor to return the share by a date in the future.

In the case that the share is not returned, interest fees begin to accrue.

In the case of GameStop, if there is a 120% short float, then there is a demand greater than the supply of shares in the market (1.2 requests for 1 share).

If retail investors on WallStreetBets manage to buy up 50% of all available shares, and hold them indefinitely (waiting for the squeeze), then you end up with a situation where those same 1.2 requests are for 0.5 shares (the demand is effectively double).

When the interest payments begin on those shorted stocks, this can begin a bidding war where those that shorted the stock are desperate to exit their positions, bidding higher and higher.

In the case of a shorted stock, this results in larger and larger losses – remember they want to buy back the share at a lower price than they sold at to generate a profit.

The sense of urgency to exit the position, only fuels the rapid increase in the stock price.

The short squeeze for Volkswagen ended up rocketing the price of a single share from under €200 to over €1,000 (some short sellers paid as much as €1,005 to close out their short positions).

RobinHood Trading Restriction

The GameStop stock was theoretically heading towards the short squeeze situation, with the stock price rising from $18 on Friday 8th January, to almost $350 a share on Wednesday 27th January.

This rise in the stock price was unprecedented, and received praise from various high-profile people, such as Elon Musk (who moved the market for various other assets such as BitCoin recently).

This only added fuel to the fire, bringing in additional troops to the WallStreetBets cause.

This ended up losing Melvin Capital as the most prominent name known to have shorted the GME stock somewhere in the region of $4.5bn.

In order to remain liquid, they needed a cash injection of $2.75bn which came from Point72 Asset Management, and Citadel.

WallStreetBets and its investors smelled blood, and pushed users to continue to “buy the dip” as the stock price rises would take them to the moon and beyond; however, there was a nasty sting in the tail to come.

RobinHood – a platform which aimed to bring investing to the masses, put a halt to any purchasing of the GME stock (and a few others that were seeing rapid rises at this time), only allowing users to sell.

As expected, when the demand for a stock dries up significantly, the share price began to tumble, resulting in stock losing almost 70% of its value in the space of a few hours.

The stock would recover somewhat, but this was a damaging move by a platform that named itself after a fictional character that “stole from the rich, and gave to the poor” – so why did they do it?

RobinHood’s Conflict of Interest?

Back in 2018, Bloomberg found that RobinHood received close of half of its profits from the sale of “Payment-for-order-flow” information of investors that use the platform.

Citadel (the find that helped bailout Melvin Capital) were responsible for processing over 65% of RobinHood payment-for-order-flow orders.

When RobinHood decided to stop the purchase of these GameStop stocks, retail investors were quick to point out the conflict of interest.

This will have crippled confidence in the platform, which was particularly damaging given a potential upcoming IPO to float RobinHood stock for the first time.

Did RobinHood Play Fair?

RobinHood CEO Vlad Tenev appeared on Clubhouse, an audio streaming app, where he was grilled by Elon Musk.

“Spill the beans, man – what happened last week?”

The explanation was that RobinHood needs to deposit money with the National Securities Clearing Corporation that is responsible for clearing and settling stock trades between brokers.

The amount of deposit required is a function of many factors, but one being the volatility of the markets, and a particular focus into certain securities.

A $3bn deposit was requested from RobinHood, which paled in comparison to the $2bn raised in total venture capital up to this point.

They managed to negotiate the deposit down to $700m, but by this point the damage was done.

Not even the fact that the restrictions on purchasing were partially lifted was enough to return confidence in the platform.

Short Ladder Attacks

The GameStop share price recovered somewhat to $325 after the RobinHood saga, and trading volumes in the market decreased significantly.

It was clear that retail investors were “HODLing” the stock, waiting for the squeeze, and the big volatility swings in the stock price were consigned to a thing of the past.

However, even with low trading volumes, the price of the stock would fall significantly, usually in Power Hour before trading closed for the day.

This lead to investors claiming foul play in the markets, with the main culprit the “Short Ladder” attack.

The “Short Ladder” is a result of two or more funds putting in lower and lower bid prices into the market between themselves.

Even with little to no volume between the trades, this is enough to push the market price lower, which reduces the loss when closing their existing short positions.

Was the Squeeze “Squoze”?

Since the GameStop stock hit almost $500 in value, it has seen a sustained drop, and has almost lost 90% of its previous peak value.

Investors that are still holding the stock still believe that the short squeeze hasn’t happened yet, but others believe this isn’t yet the case.

Unfortunately, the likelihood of a short squeeze is much greater when there are fewer shares outstanding available in the market.

As the financial markets have become an emotional game that could probably be better explained by neuroscience and psychology, rather than about market fundamentals, it is clear that the significant loss of value in the GameStop stock has resulted in multiple retail investors liquidating their positions.

It is highly unlikely that those investors who were burned by the loss will return.

What is next for GameStop? What about other “Meme” Stocks?

It does seem as though all momentum has left the GameStop stock, so I don’t believe it will ‘do a Tesla’ and continue to rise almost unabated (Tesla has far better fundamentals than GameStop).

For those retail investors that had a taste of large gains that come from day trading, having bought in early into the hype, there will absolutely be the desire to find the next big thing.

Perhaps we won’t have to wait long until we see another stock targeted in this way, unless…

Potential Regulatory Changes Incoming?

The GameStop saga brought into question the fairness of the financial markets. With the RobinHood block of purchasing rather than selling, the short ladder attacks, and the seemingly biased reporting on major news outlets, retail investors have cried out that “there is one rule for them, and another for us”.

Given talk of class action lawsuits to recoup losses incurred by the block on trading, the perceived ability for forums such as WallStreetBets to manipulate the market, and the fact that a company was able to end up with a short float above 100%, it is clear that there is appetite for change.

It will be an interesting year for the financial markets as a result of this saga – it could be argued that the longest bull market was maintained due to the creation of platforms such as RobinHood and FreeTrade giving access to retail investors.

Given that confidence in the markets will have been hit by the controversies, could we see a liquidation of assets from retail investors as a result?