What happened?
The GameStop trading frenzy has been non-stop in the last few days and is still happening. GameStop is a traditional video game retail company in the US. It is the parent company of EB Games in Australia.
This company has not been performing well financially and was seen as an exploitable opportunity for hedge funds. Hedge funds started to short-sell GameStop’s shares.
What is short-selling? Short-selling means that you can borrow a stock and sell it at the current price. Because you expect the price of the stock to drop, when that happens, you buy it back and return the stock — you sell high and buy low and make a profit.
For example, you predict that the share price of company A will fall to $15 in two months. The current price is $20. You do not own the stock but you want to make a profit based on your prediction. You therefore short sell it. First, you borrow it and sell at $20. Later the price does fall to $15, and you buy it back at $15 to return what you borrow. In total, you make $5 profit per share.
Short-selling allows you to sell something that you do not own! According to academic research and regulators’ statements, short-selling improves market efficiency and corrects the stock market from over-valuation and bubbles.
Usually, when hedge funds have their eyes on companies and start to short-sell, stock prices will drop. The market believes in their assessments.
This time is different! Hedge funds are playing fire with GameStop, a company that reflects the fond childhood memories of many gaming lovers on Reddit.
As a result, a group of traders on the WallStreetBets sub-forum on Reddit gathered an army to intensively buy the shares of GameStop. In recent years, a low-cost trading platform called Robinhood has gained a large market share in attracting retail investors, which is why we also call this army ‘Robinhood traders’.
According to the law of supply and demand, when demand goes up, the price of a stock goes up.
Consequently, the share price of GameStop has gone up from around US$20 to a peak of $469! Hedge funds that have borrowed the stocks will have to buy at much higher prices to cover their positions. That’s how they have incurred \ huge losses. In the process of buying the shares, hedge funds would further increase the prices to magnify their losses. This is a short squeeze.
Low-cost trading platforms encourage stock market participation from retail investors.
What are the implications?
There are three major factors that fuelled the GameStop saga. First, the COVID-19 lockdown has driven the dramatic surge in retail trading in the US and around the world. Data has shown there was a 50% jump in global trading volumes (looking at 37 developing and developed countries) during the pandemic.
Second, recent years have witnessed a number of low-cost trading platforms such as Robinhood in the US and Superhero in Australia. Low-cost trading platforms encourage stock market participation from retail investors.
Third, Social Trading, which refers to the discussion of investment on social media, has been trending. There are a large number of trading groups on Facebook, investment channels on YouTube, influencers talking about trading on TikTok, and more importantly, discussion forums such as Reddit and HotCopper.
In Australia, ASIC is concerned about Social Trading and has warned retail investors to be cautious about copy trading offered by low-cost trading platforms such as eToro.
What are the hottest stocks among social traders in Australia as seen on Reddit and HotCopper? The BNPL (Buy now pay later) stocks are definitely among the hottest and the large surge in their price is partly related to retail trading.
Angel Zhong - School of Economics, Finance and Marketing
