Short squeeze and GameStop: why is everyone talking about it?

Overnight gains and losses: Understand the case of the traditional retailer whose stock was the most traded on Wall Street.

 

You have a company. There’s nothing exceptional about it – in fact, sales have been falling year after year. Except that, out of nowhere, her shares appreciated by 1,800%.It’s not magic, it’s not bugs, it’s not fake news. It really happened with the American company GameStop, a traditional chain of video game stores that has been registering poor sales results in recent years.Through a stock market ploy called short squeeze , a group of investors managed to make the retailer’s shares (which lost $795 million in 2019) jump from $19.26 to $380 by the end of December and the 27th of January.

Basically, several funds had been betting that the company’s shares would fall. But the movement of these smaller investors turned all predictions upside down.

This phenomenon fascinated (and confused) many people. Understand how it happened.

What is short squeeze?

Short squeeze is a market movement that happens when an asset (such as a stock, for example) rises sharply – causing investors who were betting on its decline to buy it quickly, to avoid bigger losses.

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Going back a little bit – stock exchanges are basically spaces where assets are bought and sold. There are two main ways to trade these asset trades: long and short .

  • Trading long: when you buy a stock betting that it will go up – that is, that you can sell for a higher price than you bought. Another term for this is trading long.
  • Trading short: when you trade a stock betting that it will go down. It is also called short trade.

The first case is easier to understand. But why would anyone trade a stock betting it will devalue?

Basically, think that these traded shares are being rented :

  • A fund borrows the company’s shares from other investors;
  • The fund sells them at today’s price;
  • The plan is then to buy again (believing that the future price will be lower) and return it to the original owner.

The short squeeze happens when this bet backfires: instead of the price going down, it goes up – and the fund ends up having to buy at a higher price than expected, before it goes even higher.

Another way to “bet against” a stock is through a type of security called an option . Whoever buys this bond is guaranteeing the right to trade an asset in the future for a specified price. It is a kind of contract between two parties: one of the parties operates long (bet on the rise) and the other party trades short (bet on the fall).

For example, a stock costs $5 today. A fund trades an option that allows it to buy that stock for $8 three months from now. If, getting there, the stock is worth more than $8, the fund will profit (because it is paying less than it is worth). If it is worth less than $8, the fund is at a loss.

And where does GameStop fit in this short squeeze story?

GameStop’s actions weren’t doing very well. Therefore, until then, they were a big target for short operations – that is, funds betting that their shares would fall even more in the future.

But what happened was just the opposite: GameStop’s shares soared insanely because of an organized investor movement on the internet.

Within a Reddit community (one of the biggest online forums in the world), a group decided to play against analysts who always predicted downfalls on GameStop. These investors bought the company’s shares in droves.

With that, GameStop’s stock value started to grow. The result was that, to avoid further losses, many funds had to buy the shares before they rose further.

And what happens when the demand for something grows? Yeah, the price goes up.

The funds repurchasing the shares and the interest the case generated created a loop in which GameStop’s shares soared. Many of the people who had lent (leased) their shares to the funds asked for it back, forcing those in a short position to buy back the much more expensive assets. In other words: there was a short squeeze .

To further complicate matters, according to the rules of the American stock exchange, those who trade in shorts must have deposited part of the value of the shares as a “guarantee”. In other words: when the stock triggers, the fund needs to pay an amount for this “guarantee”.

The results are not yet clear, but there is speculation of billionaire losses for the funds that operated the company’s shares in short.

How is it possible for something like this to happen?

There are several other technical details in this story, but what is most striking is the almost fanciful character of GameStop’s valuation.

The company continued with its timid results, an analog model, did not make any move that would justify a rise of this size – despite recent news showing the entry of new advisers linked to the technology market.

But investors were able to use market mechanisms to influence its value.

This case shows that although the stock market operates under more normal conditions most of the time, speculation is capable of causing huge gains and losses – often based more on frenzy than on concrete results.

Remember that, just as it went up, GameStop’s shares could fall precipitously. The US regulator and some companies are even studying blocking or limiting the trading of GameStop assets – which, in turn, is causing a lot of controversy.

As a result, in Brazil and the United States, other investors have also started to organize themselves to make a similar “short squeeze” with shares from other companies .

The danger remains the same: at any moment, speculation can turn to the opposite side and cause great harm to many people. Those who do not have a good grasp of stock market movements can do very poorly.

 

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