This past week, stock markets saw increased volatility due to frenetic retail trading behavior in certain heavily shorted stocks. Amongst others, the stock or company at the centre of the spotlight was GameStop, a retail and online provider of console games. Since July 2020, GameStop’s stock price has increased tremendously from $4 to peaking at over $450 dollars. For many retail investors, this speculative bubble has led to one in a lifetime stock market gains, with a single trader turning $55,000 into over $44 million over the span of a year.
GameStop’s meteoric stock price can be explained through a stock market phenomenon known as a “short squeeze”. Taking a step back, a short position is defined by a trader borrowing a stock to sell it and then repurchasing the stock at a lower price in the future. When shorting a stock, the trader does not necessarily need to own the stock. Rather they can borrow it from someone else (for example a stockbroker). Traders who hold short positions hope to make a profit through large declines in a company’s stock price. In GameStop’s situation, many hedge funds (institutional investors with billions of dollars to manage) had significant short positions in the stock. However, retail investors saw this as an opportunity to engage in a short squeeze through collectively buying the stock to push it up. Retail investors largely collaborated through online forums such as r/WallStreetBets (with ~6m users on Reddit) and Discord.
A short squeeze occurs when a heavily shorted stock starts increasing in price (because of significant buying activity), forcing short sellers to “cover” their positions to avoid further losses. This is because short sellers have the obligation to purchase the stock back in the future and rising stock prices means a higher cost of repurchase. As short sellers “cover”, they purchase the underlying stock, creating more demand for the stock that pushes the stock price up even higher and causes other short sellers to cover. This virtuous cycle is known as a short squeeze. The result is the potential for the stock to go “to the moon” i.e. rise without limit.
As this is being written, the situation in GameStop has not yet expired with many retail investors still buying in to the stock and more hedge funds putting on short positions. In a way, this can be seen as the average Joe versus Wall Street (hedge funds). The media and wider public are rooting for the underdog and next week may lead to even more volatile stock market activity.
While the speculative bubble has largely been limited to a handful of stocks, the fact that these bubbles are occurring is reminiscent of the tech bubble at the start of the century (2000-2001) and the period prior to the GFC. In both contexts, the stock market soared to unprecedented highs as more and more money flowed in, driven by low interest rates, large amounts of savings, and the lack of suitable investment alternatives. As a result, we are likely approaching what economists call a “Minsky moment” defined as a period where excessive risk taking creates a highly precarious financial environment that could collapse under the right catalyst.
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