Legal Question: What's the Deal with Meme Stonks and GameStop?
This week’s question comes from @ellebeabea on Instagram.
“Can you please explain this GameStop thing in the same way you explain all financial and legal matters on the podcast? I get it very basically: X Jerky Companies bet against GameStop and X GameStop Patrons said EFF YOU WE ARE GOING TO MAKE YOU PAY FOR BEING A JERK TO OUR FRIEND. I don’t understand the aftermath. Help!!!”
I got you! This past week has been a rollercoaster ride for the financial news programs. I leave CNBC on in the background while I’m working sometimes, and they’ve been UP IN ARMS about what’s going on with GameStop stock. But... wtf IS going on?
[If you don’t want to read all this, skip to the bottom for a three line summary.]
A couple things before we get started: I used to work for a hedge fund. *crowd gasps* I had my investment adviser license and worked with a portfolio manager who traded options - both long and short (we’ll get into what all that means). HOWEVER, much like none of this is usually legal advice, so too, none of this is investment advice.
So... here’s the deal. We’ll start with stuff you need to know, then get into how it applies to the GameStop scenario, then talk what may happen next.
STUFF YOU NEED TO KNOW - Feel free to skip if you know these concepts already.
“Going short” or “Shorting a stock” - If you believe a stock price is going down, one way to make money on it is by “shorting” that stock. This means you borrow the stock from a broker at its current price - say, $10 per share - believing that at a later date, it will be worth less. When it is worth less later, you would be able to pay back those shares for the lower price. Ideally, at that later date, the price will be something like $5, so you can buy it back from the market at that lower price, give back the stock you owe, and pocket the $5 difference.
Sounds pretty lucrative, right?
Well, the danger is a scenario in which the stock price goes up. You’ve borrowed it at $10, saying you’ll deliver it on some later date. But that later date comes, and the price is now at $300 per share. You will have to “cover” the shares you owe by buying them from the market at $300 in order to make good on your promise. Your loss is $290 per share.
GameStop’s Business - Lots of folks feel nostalgia for waiting in lines to buy the newest game at GameStop. Hanging out, browsing games on a Friday night. Heading to your local mall and trading in your old games for pennies. That all used to be really fun. Now, a majority of people buy games online in digital format, meaning for the past 5 years, GameStop’s underlying business has been declining. It’s been bleeding money which drove its stock price way down. It traded at around $30 per share in 2016 then hit about $5 per share in mid-2020. Seems like a safe stock to go short on, right?
Hedge Fund - A hedge fund is a bucket of rich people’s money that is invested by a professional money manager in the stock market. The term “hedge” comes from the idea that they use financial instruments to protect the portfolio from swings in the market - kind of like the phrase “hedging your bets.” It is true that some funds actually hedge. However, other funds trade wildly on really risky endeavors that create huge returns but come with huge risks, without ever really hedging at all.
Reddit / WallStreetBets - Reddit is a social media and news discussion website. Users set up a username (something like TEXAS_POON_TAPPA) and submit content to the site such as links, posts, and images. Other members then vote up or down on the posts, so that the posts can be ranked by the most popular. It is separated into “sub-reddits” or topic-specific forums dedicated to things like fitness, movies, TV, music, or investment ideas. WallStreetBets is a subreddit where folks gather to trade hot stock ideas and even hotter memes.
Robinhood - A supposedly user-friendly online trading app that allows average Joes like you and me to hop on and trade stocks without paying any commission. It’s quick and easy primarily because it is “self-settled,” meaning they’re supposed to keep cash on hand to cover trades made by their users rather than relying on an outside source of money.
Robinhood doesn’t charge its users to make trades, mostly because Robinhood gets paid for routing customer orders to certain trading firms for execution who were willing to pay Robinhood for the privilege. This got them in trouble with the SEC back in December 2020 as they were busted for giving their customers inferior prices for trades because the trades were not routed to the most efficient trading firms, but to the trading firms willing to pay the most to execute the order. (That's a lot of yadda-yadda-yadda stock market speak, but it's important to know they’ve been in trouble before.)
HOW DOES THIS APPLY TO GAMESTOCK?
A large hedge fund called Melvin Capital was known around Wall Street for shorting GameStop’s stock. Melvin Capital was founded by Gabe Plotkin in 2014 with $925 million in seed money. Plotkin is a minority owner in the Charlotte Hornets, and in December 2020, bought a Miami mansion for $44 million. All that to say - he was doing all right. The fund was considered one of Wall Street’s best performers. As of December 2020, Melvin Capital managed $13 billion.
By being “short” GameStop at its 2020 price (somewhere around $15 bucks a share), Melvin Capital was betting that the price would drop below that. When the fund closed out its position on Tuesday, January 25, GameStop traded at $147.98 per share.
Ouch.
After its GameStop trade went sideways, Melvin allegedly lost 30% in the first three weeks of January alone. In response, two other prominent hedge funds “extended a financial lifeline” to Melvin Capital to the tune of $2.75 billion.
As you can imagine, a 30% loss is a very bad return for a hedge fund.
WHY DID GAMESTOP'S STOCK PRICE GO UP?
Short answer - for shits and giggles. Users on the WallStreetBets subreddit decided to buy GameStop. Why? The answer was simple: “WE LIKE THE STOCK!” Users decided Melvin’s bet against GameStop was wrong, inaccurate, unfair, and best of all, an easy target.
This is nothing new. When a big hedge fund player is short a certain company and another fund manager finds out, that second manager can begin buying the underlying stock. When the stock is bought, you cause what is known as a “short squeeze.” The price goes up. The person who bets against it wants to stem the bleeding so they buy the stock to cover their short bet. This causes the stock to go up even more.
People traded so many shares of GameStop on Monday - 175.5 million shares to be exact - that the stock exchange had to halt trading nine different times. The market circuit breakers kick in and halt trading when excessive volatility happens in a name or an index.
GameStop went from $39 per share on Tuesday the 19th to $325 per share on Friday the 29th. You don't have to know anything about the market to know - that's a huge move.
The trading was so frenetic that Robinhood had to stop allowing its users to buy shares on the 28th and has restricted the amount of shares users can buy since then. This has to do with a lot of boring regulatory requirements but shows that Robinhood was NOT prepared for an event like this.
This uproar has completely derailed their prospects of going public, which would have made a lot of money for the company and its owners, which includes hedge funds. It has also subjected Robinhood to at least one class-action lawsuit on behalf of its users. Congress and the SEC are also looking into the company's actions as well.
WHY IS THIS SUCH A BIG DEAL?
Normally, hedge funds are being bet against by other hedge funds or investment professionals. Hedge funds are subject to investment strategies, which are explanations to their investors as to how they invest. They’re required to stick to these self-created rules. Investment professionals also generally adhere to certain norms. For instance, selling out of a position once you've reaped a big enough profit or if the underlying company is losing money.
This situation is different because it is not a case of hedge fund versus hedge fund. This is a case of hedge fund/the market overall versus some very dedicated users on Reddit. The Redditors have no investment thesis except “WE LIKE THE STOCK,” “HOLD,” 💎🙌 (diamond hands - meaning hold the stock no matter what), 🚀🌝 (stock is going to the MOON!), and a couple of others I won’t repeat here.
Where the market, experts, and hedge funds can somewhat predict the moves of another hedge fund - they cannot predict the moves of this WSB crew. Talking heads on CNBC cry that the “fundamentals” of the company - meaning how much it earns, how much it spends, and its long-term prospects for profit - are bad. Based on the fundamentals of GameStop, its stock should trade $10-15 dollar at most. But the WSB crew doesn’t care about fundamentals because “WE LIKE THE STOCK!” There’s no reasoning with the internet.
HOW WILL THIS PLAY OUT?
At this point, no one knows. The WSB crowd wants to see the GameStop stock go “to the moon” - meaning $1000, $4200, $6900, $10,000 or even $42,000.69 per share. Will it ever get there? I doubt it. GameStop itself can profit from this by issuing new shares. Once that happens, the supply of available shares will increase, meaning the price will necessarily go down. When will that happen? It's anyone’s guess.
In the meantime, Melvin Capital announced it got out of its position on Tuesday at a substantial loss. Some Redditors believe this announcement was a lie, but if it really was a lie, Melvin Capital would be in trouble for making misleading statements and get smacked by the Securities and Exchange Commission (the SEC) which regulates the stock market.
There could be others who may be short GameStop, but at this point, there’s not a sure-fire way to know.
Additionally, the SEC stated it was “aware of and actively monitoring” the current markets.
Some legal experts believe this could mean the SEC will halt trading on GameStop or that the SEC will investigate the Reddit posters for market manipulation.
This scenario has some similarities to old “pump and dump” schemes where scammers would make unsolicited phone calls or send emails touting the value of a penny stock in order to artificially inflate the price. They would lie to investors, saying some big announcement was coming or that the company was on the verge of revealing a new product. The scammers would then sell high, pushing the price back down, and the suckers at home would take the losses.
The key difference here is .... nobody was hiding anything. The Redditors weren’t lying and saying there was some big announcement on the horizon that would cause a pop. They didn’t say the stock was undervalued. They simply said, “WE LIKE THE STOCK!” If you like a stock, and you post online that you like the stock, are you committing fraud? I’d say no, but then again, I don’t work for the SEC.
I think if the government attacks individual retail investors for posting their ideas and favorite stocks online, the backlash would be unreal. I also bet that least one Redditor would have Mark-Cuban-money enough to challenge the regulators on an argument of free speech. Perhaps user “DeepFuckingValue” who is allegedly up several million dollars on the trade.
SHOULD I BUY GAMESTOP?
An amateur trader should put the same amount of money into the market as they could afford to lose in a casino gambling or burning up in a furnace. If you can’t afford to lose it, don’t risk it.
I DON’T WANT TO READ ALL THAT. WHAT’S THE SHORT VERSION?
Big rich man bet that a stock would go down. Amateurs from the internet caused the stock to go up because they liked the stock and bought it. This made big rich man lose money, broke trading apps, and disrupted the market. No telling what Congress or the SEC have in store, but there are some changes coming for Wall Street. And it’ll all be because of TEXAS_POON_TAPPA and friends. 💎🙌 🚀🌝
I hope that answers your question, ellebeabea! Thanks for sending.
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This piece first appeared in Sunday Morning Hot Tea. Subscribe so you don’t miss another piece.