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GameStop: Squeezed to the Max | Brian Feroldi | EP 293

Wondering what happened with GameStop and confused about what a short squeeze is? The complexity of this kind of trading is far from the simple strategy of buy and hold investing.

Brian Feroldi

What You’ll Get Out Of Today’s Show

  • Even for those who have no plans to jump on the GameStop (GME), it’s good to understand exactly what is going on. We can learn what’s happening, how it works, and move intelligently forward.
  • In an effort to understand systems, Brad has been having a maddening healthcare experience. He needs a CT scan but hasn’t been able to find out what the base cost will be. The negotiated cost won’t be known until after the procedure so Brad won’t know how much it will cost him until then.
  • At a macro level, the stock market has had a fairly smooth move up and to the right for the past 10 years or so. For investors, it’s been somewhat predictable, at least until this last week when GameStop stock began to skyrocket.
  • There are aspects of the stock market the average investor doesn’t see. Hedge funds are participating with huge amounts of money in layers that are essentially hidden to the masses, until it wasn’t, and they got caught unaware.
  • Brian Feroldi says the last few weeks have been some of the weirdest in the investing world that he’s ever seen. The story has infiltrated mainstream culture and he’s been getting questions from all over about what is going on. Even his mom sent a text asking about GameStop.
  • First, GameStop is a physical seller of video games. As video games became popular, GameStop was a great investment, however, once people began downloading video games, its business prospects declined. As a result, GameStop stock prices have also been declining for many years and it is believed they will cease to exist as a business in a couple of years.
  • Investors or many managers can make money when a stock declines in what’s called shorting the stock. A short sale stock is the opposite of becoming a buy and hold investor in a stock.
  • A short sale works by going to your broker predicting a stock’s decline and state you want to short that stock at a particular price. The broker goes and borrows shares of the stock from another investor for the price you stated and you collect the proceeds from the sale. Your goal is to then buy those shares back at a later date for a lower price and return them to the original investor.
  • The original owner of the stock makes money by receiving a small fee from the person borrowing their stock, almost like being charged an interest rate. The more demand there is to short a stock, the higher the fees.
  • There is no set timeframe when shorting a stock. I can be shorted indefinitely. However, if the owner of the stock wants to sell it, the broker who borrowed the stock would have to go and find another short for you to borrow from. If they cannot find other shares to short, the transaction would need to be undone on the short side at current market rates.
  • Most of us take long positions on stocks, believing the stock is going to increase in value. Allowing someone else to borrow your stock in a short position is another way to make money on owning it.
  • Some brokers like Brian’s are interactive and sent him an email asking if he would be interested in allowing his stock to be borrowed or shorted. since he’s interested in holding the stocks for a long period of time, he said yes.
  • Shorting a stock does put downward pressure on the share price. Individual investors don’t have much influence, but a hedge fund taking a significant position to short a stock can drive prices down.
  • The market price of a stock at any given time is simultaneously the lowest price buyers are willing to pay and the highest price sellers are willing to sell at.
  • Shorts are happening all of the time, so how did GameStop land on the radar of the subreddit group, Wallstreetbets? In the case of GameStop, there were more shares sold short than there were publicly traded, which is something that very rarely happens.
  • Wallstreetbets took the opposite position, stating that GameStop’s fundamentals were different from companies like Blockbuster, and its stock price was actually undervalued.
  • An article by Andrew Left from Citron Research predicting GameStop stock going down hard caught the attention of Wallstreetbets. Its members rallied together to buy GameStop stock.
  • It was then that GameStop stock began to rise. Someone with a short position on a stock does not want to see the price rise. Rising GameStop prices kicked off what’s called a short squeeze.
  • There’s no logical argument for saying that GameStop stock was worth $4 in December and $400 just three weeks later. What shifted was who was controlling the mechanics of the system.
  • The members of Wallstreetbets understood that due to the large number of short positions on GameStop, if enough of them got together to buy it, they could force those in short positions to buy back into it.
  • GameStop was priced for bankruptcy. While there’s no limit to how high a stock can go, the lowest it can go is $0. In that case, the short seller earns a 100% return on their money. However, when a stock rises, being short on a stock can cost significantly more than you put into the stock.
  • To get out of a short means you have to buy the stock. The buying demand placed on the stock increases the share price. When all of the short sellers saw GameStop’s stock price rise, they had to try and get out by undoing the trade by buying the stock themselves, putting more upward pressure on the stock price and on other short-sellers who wanted to undo the trade. That’s why GameStop stock prices rose so dramatically in such a short period of time.
  • Short squeezes are not a new phenomenon. In the past, other heavily shorted companies have come out with good news and saw their stock prices skyrocket. What makes the GameStop situation unique is that it resulted from a coordinated group of buyers banded together to make it happen.
  • In this short squeeze, there was additional controversy surrounding Robinhood, the zero-commission broker. Because Robinhood doesn’t make money on trades, they make money by selling your trading information to high-frequency traders who can make money with micro-transactions. It’s those traders who are the real customers of Robinhood.
  • When GameStop and other heavily shorted stock prices began to rise, Robinhood’s hedge fund customers began to lose a lot of money so Robinhood decided to stop trading with these stocks to give the hedge funds time to undo their trades. Meanwhile, Robinhood’s small investors were not allowed to buy and sell.
  • Robinhood aggregates and sells client trade information to the high-frequency traders who can buy the stocks then turn around and sell it to the Robinhood client seconds later for a little extra money.
  • Robinhood’s business model probably works out for a buy and hold investor at the micro-level, but the GameStop situation highlights what can go wrong when each other’s incentives are not aligned.
  • What this demonstrates is that the game is stacked against an individual investor trying to enter and exit the markets with precision. But for the buy and hold investor, this has been mostly noise.
  • To summarize what happened this week, Brian quoted Morgan Housel who recently tweeted, “The GameStop thing is a reminder that investing is not the study of finance. It’s the study of how people behave with money. And sometimes those behaviors are incredible.
  • Brian says there has been a huge rise in demand for Environmental, Social, and Government (ESG) funds. The exact definition of what ESG investing means varies from person to person so read through the fund to ensure it meets your definition. There are a lot of ESG funds to choose from now and fees have gone down, especially since Vanguard now has an ESG fund.
  • If you listened to Monday’s episode on M1 Finance, M1 does not sell mutual funds, they sell ETFs. The ETF version of VTSAX is VTI.

Resources Mentioned In Today’s Conversation

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