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Retail Investor of the Century – Choosing GameStop

On Sunday, September 8th, 2019 at 4:12 p.m. a man named Keith Gill made a quiet and seemingly ridiculous post on the Reddit forum r/wallstreetbets. Keith Gill posted a picture of his E*TRADE account showing that he purchased over $30,000 worth of GameStop shares and $53,566.04 worth of January 15, 2021 call options.

What-Happened-With-GameStop-Stock
Source: https://search.creativecommons.org/photos/9cffb24f-f0a6-4fb4-b074-7366035b1e20

The subreddit r/wallstreetbets is known for outlandish investment positions that individual investors make. At the time of Gill’s first post, the subreddit was still an on-the-fringe financial discussion subreddit having less than 1 million users. The forum is filled with people who have made massive bets to become millionaires overnight and many more that have lost their entire life savings on what they imagined to be a sure bet. In Gill’s case, many users commented on the post stating that he was going to lose it all. Investing in GameStop was likened to investing in Blockbuster Video in the company’s dying days. The commentators were sure that investing in GameStop would be a surefire way to lose everything he owned and GameStop was destined to go bust. However, GameStop did not go bankrupt. Instead, we have an inspiring story of how individual retail investors took on Wall Street and one of the most insane short squeezes to ever occur. The events of January 2021 left financial professionals with their mouths agape as everyone asked “what happened with GameStop’s stock?”

What are Options Contracts? – Call Options

To understand short selling and short squeezes there needs to be some background into what a financial option contract is. There are many great resources all over the internet explaining this concept in a detailed explanation, but I will provide a brief overview of call and put options. Call options are slightly easier to wrap ones brain around so we will start there.

Imagine that Sally is selling seashells by the seashore for $10 a shell. As the savvy businessperson that you are, you believe that the price of seashells is going to go up in the future due to some market analysis or a hunch indicating a price increase.

You offer Sally a deal and tell her “I will give you $1,200 today so that I can buy 100 seashells any time between now and the next 6 months for $10 apiece.”

Sally responds, “Okay, I’ll take $1,200 today. I don’t have to sell you any seashells now. I have only sold you the rights to purchase seashells at $10 apiece from now until 6 months later.” Sally the seller, pockets the money immediately and does not have to give you, the buyer, anything except for the rights to purchase the 100 shells for $10 each in the future.

As the buyer, you purchased a contract to buy 100 shells at $10 apiece. The value of the assets underlying the contract is worth $1,000 (100 shells * $10). The shells could be purchased at the current market price of $1,000 but you spent $1,200 for this contract. The $200 difference is the premium to purchase this call option contract.

The breakeven price on this contract is $1,200 (the cost of the contract) divided by 100 (the number of shells/shares you receive from the contract) which means that $12 per shell is the breakeven price. To make money on this contract, the price of seashells needs to increase to at least $12.01, otherwise, you would have been better off simply buying a seashell at the current market price.

If the price of seashells is $15 three months after the call option was purchased, the buyer can exercise the call option. As the buyer, you can now purchase 100 seashells for $10 each, but each shell is worth $15. The breakeven price was $12 so there is an immediate increase to the value you receive as the difference between the market price of the asset and the breakeven price ($15-$12). You have now made $3 on each shell and the contract allows you to purchase 100 shells. You have made $300 ($3 * 100) on a single contract simply because the price went up and you made a bet.  

Now imagine that you have purchased thousands of call option contracts and the profits will multiply rapidly. On the flip side of a call option, if the price did not reach $12 per shell you could purchase the seashells at the current market price and would have only lost what you spent on the price of the call options which is $1,200.

What are Options Contracts? – Put Options/Short Selling

The opposite of a call option is a put option. If you think the price of seashells will go down because you realize the seashore is truly the worst place to try and sell seashells, then you would want to purchase a put option or short sell the stock.

Using the same example as before, if Sally is selling her shells for $10 each and you believe the price will go down to $3 a shell, you will engage in a short sale. The conversation will go something like “Hello Sally, I am going to borrow 100 seashells right now, but I will not pay you anything just yet.”

Sally would respond and say, “Okay, I have thousands of seashells so you can borrow 100 of them and you’ll pay me for the shells later at whatever the market price is.”

As soon as you receive the shells from Sally, you immediately sell all 100 shells as fast as you can for the current market price and make $1,000 (100 shells * $10). This $1,000 from the sale will be held by you or your broker in a margin account. This margin account will have the amount from the sale along with a margin percentage of the money that is required by the brokerage for this transaction to occur. The margin amount is usually about 50 percent of what is deposited. In this case, 50 percent of $1,000 is an additional $500 you need to put into the account.

If three months after you sold the shells and the market price of shells have now gone down to $3 per shell as you predicted, you will now close your short position. You will buy back 100 seashells at $3 per shell and return them to Sally. The shells now only cost you $300, but you sold $1,000 worth three months ago. Your profit from the transaction is $700 and the margin amount you put up to engage in the short sale is returned to your accounts.

If you the reader are still having trouble understanding the concept, I encourage readers to take a look at some different explanations regarding financial options contracts.

Short selling has its risks, but short-sellers are usually financially adept hedge funds and institutional investors. When a stock is heavily shorted it signals to the market that a company might be in financial trouble and many investors tend to steer clear of these heavily shorted companies. Short sellers can engage in short selling long enough to drive the price of a company stock down to the point where they must declare bankruptcy due to insolvency.

Setting the Stage for What Happened With GameStop Stock

There are two major players in this story, individual retail investors, particularly those on r/wallstreetbets, and Wall Street institutional investors and hedge funds such as Melvin Capital.

Melvin Capital was a hedge fund founded back in 2014 and has been a notorious and successful short seller. The fund itself has achieved around 30 percent annual returns up until the beginning of this year. The hedge fund took a short position on GameStop along with several other hedge funds and this position indicated to the market how financial institutions thought GameStop was destined to go bust.

The number of shares of stock available and outstanding is called the float. Publicly available information in 2020 and early 2021 showed that by the start of January 2021 an estimated 139 to 141 percent of GameStop’s float was being shorted.  In other words, GameStop had more shares being shorted than there were in existence. This is extremely important because there is another side to each transaction. Melvin Capital and other hedge funds were hoping the reckless and risky short position would drive GameStop towards insolvency and eventually into bankruptcy so they would not need to repay to GameStop the shares they had shorted.

A few investors became wise to the excessive short position and had believed GameStop was not in as dire straights as many hedge funds believed. One such investor that believed in the value of GameStop was Keith Gill who was mentioned at the start of this article. Another famous investor that believed in the value of GameStop was Michael Burry, one of the few who predicted the housing market collapse in 2007 and is portrayed by Christian Bale in the film The Big Short. Burry invested in GameStop shortly after Gill.

The public support by these two investors, one was little known and one of the most famous and successful investors of all time garnered internet attention to GameStop. In addition, Gill made frequent posts showing unrealized gains from his GameStop position leading up to January 2021. Gill was showing well over two million dollars of unrealized gains by Christmas of 2020 and had documented the growth of his position since 2019 publicly.

The incredible success by Keith Gill prompted many of the almost two million users of Reddit’s r/wallstreetbets to begin looking into GameStop to see if they too could jump on the easy money bandwagon. By the start of the new year, r/wallstreetbets was full of technical analysis and posts regarding GameStop’s stock and the underlying factors that might drive up the price. The 141 percent of float being shorted caught the eye of anyone with a brain realizing the implications. The principle of what happened to GameStop stock next is primarily a function of supply and demand.

When hundreds of thousands of retail investors flocked to purchase call options or shares of GameStop, the price of the shares and the value of the call options began to increase. Since the price of the shares began to increase, the put options held by those shorting the stock became unprofitable. As mentioned before, put options carry a tremendous risk of unlimited liability and the need to put up a margin percentage based on the value of the puts for liquidity reasons.

Call option losses are limited to what the buyer paid for the call options. If the call options are not exercised, then the buyer simply lost what they paid for the options. Put options, on the other hand, have gains that are limited to the difference in the value of the option and if the price of the share went to zero. If the price of the stock being shorted goes up, the short seller is liable for theoretically infinite losses.

GameStop Mania – The Short Squeeze

The dice were cast, and the buyers of GameStop stock were in what was thought to be a perfect position. As long as thousands and millions of dollars kept purchasing GameStop shares and call options, the short sellers would be unable to close their positions without taking massive losses. If the short sellers closed their positions it would simultaneously drive the price of GameStop higher as well. As the price of the stock went higher, the stock exchanges feared for the liquidity of the markets and made what is known as a margin call. In essence, the short seller would be required to pay the margin premium on the firm’s short positions to maintain the put options. With the price of GameStop soaring to astronomical heights, the margin calls were exorbitant.

The liquidity crisis for many hedge funds and other short sellers became so dire by January 25, 2021, that these funds needed to borrow billions of dollars to cover their margins. That’s right, billions of dollars, with a B. At this point, the individual retail investors were making money hand over fist and GameStop was approaching the peak value at the height of the short squeeze.

To show how fast money was multiplying in the hands of retail investors, Keith Gill posted on January 26th that his unrealized gains totaled $22,845,638. On January 27th Gill posted another image showing his unrealized gains had reached $47,973,298 which was more than double his position the day prior when GameStop shares reached a peak around $480 per share. The multi-billion-dollar loan that Melvin Capital received just to cover their margins was used entirely in two days due to the insane growth in GameStop’s share price. The situation was best summarized by the famous economic John Maynard Keynes who wrote,

“The markets can remain irrational longer than you can remain solvent.”

The internet was inspired, r/wallstreetbets was exploding with the platform jumping from around 2 million to nearly 8 million users within two days. Many more retail investors began to jump into the short squeeze believing the position was unstoppable so long as people kept buying more shares. More people began to post their gains and financial analysis showing that buying GameStop was the right move, that they were all going to be rich and knock out some hedge funds along the way. The dream was short-lived.

GameStop – The Fall

On Thursday, January 28th, 2021 the stock exchanges and brokerages did something that no one expected. The ability to purchase GameStop shares or options was halted completely. Investors could no longer purchase shares of GameStop, only sell shares. The effect on the market was immediate. Without the ability to continually purchase shares the short-squeeze had been ended artificially by the stockbrokers and exchanges. This halting of trading prompted immediate outcries of anger from anyone invested in the stock. The move to halt trading was so sudden and blatantly manipulative on the market that even Republican Senator Ted Cruz and Democratic Representative Alexandra Occasio-Cortez agreed that the decision to halt purchasing GameStop required investigation.

The events that transpired shortly after January 28th, 2021 is where you hear of many people losing vast fortunes because they bought into the frenzy too late before the market cracked down. One man even lost $20,000 on borrowed money and lost it all due to the changing market conditions. Many sold their shares, and the weekend after January 28th, 2021 provided hedge funds and other short sellers time to gather enough capital to begin closing out their short positions on the following Monday. It is still unclear exactly what happened in the aftermath of the brokerage’s decisions to halt trading but a congressional hearing was called on the matter.

The congressional hearing delves more into the nitty-gritty details of what happened on January 28, 2021, and the market conditions that led to the trading of GameStop and other securities being halted. The entire U.S. House Committee on Financial Services Congressional hearing is publicly available on YouTube and other streaming services if you want to dive even deeper into the topic. However, one worthwhile note is Keith Gill’s testimony which is honest, humorous, and shows the man’s great ability to remain humble despite the public and insane rise to multimillionaire status.

Where is GameStop Stock Priced Today?

At the time of this writing, GameStop has regained its second wind, maybe even third wind. The price of the stock is sitting around $160, and GameStop may reinvent itself to truly becoming the future gaming hub of the 21st century as Keith Gill predicted. According to publicly available information, the short position on GameStop is only 15 percent of the float so it appears the short squeeze it over, but there may be new changes in the future for GameStop. New C-suite leadership changes and announced plans to reform the company’s mission appear to be maintain the high price target of the stock even without the short squeeze.

It is important to remember that trading financial securities is always a risky business. Nothing is ever certain except that there most certainly will be winners and losers in any financial situation. I think back to the scene in the film The Big Short where a couple of short-sellers are excited about the position they have taken. The short seller’s mentor becomes enraged at them and says

If we’re right, people lose homes. People lose jobs. People lose retirement savings, people lose pensions. Do you know what I hate about f*cking banking? It reduces people to numbers — every 1% unemployment goes up, 40,000 people die, did you know that?

Ben Rickert – The Big Short

The 40,000 people dying has been studied to be only a slight exaggeration, but people still suffer when irresponsible games are played in the financial markets. That is not to say that investing should be left in the hands of the wealthy and few in numbers. I argue for the opposite.

Many individual investors and institutional investors alike became fabulously wealthy from their positions in GameStop. The hedge funds and short sellers that took heavy losses on their positions likely managed retirement savings or pensions that took heavy losses, and people definitely lost their jobs. There is always a flip side to every story, but the actions of individuals such as Keith Gill can inspire changes and prompt people to take action. By finding something that no one else sees and sticking to your guns when everyone tells you that your idea is crazy is what makes this life so insane and wonderful. The internet is truly the great equalizer with the share of information being we all have the power to take control of our financial lives. Heck, why not make a crazy bet or two and see if you too can’t be a retail investor that beats Wall Street at their own game?