By now, most of the world has become aware of the chain events that have led to the GameStop squeeze. However, if you are struggling to understand what has happened, firstly, you are not alone, and secondly we are here to help simplify it all into something a bit more palatable.
What is a ‘short’?
A short is created when a trader borrows a stock from a broker and then sells it on immediately at its current price. This is in the hope that the price of this stock will fall, at which point the trader can repurchase the stock at a lower price, return the shares they have borrowed from the broker and pocket the difference. Of course the key for any trader engaging in this activity is the belief that the price of that stock will fall in value.
Taking the example of GameStop, let’s say the trader borrowed a GameStop share and sold it straight away for $10. That trader now has $10, however, they still owe the broker the GameStop share. It is the traders hope that the value of the GameStop shares will fall, and they will then be able to buy that share back at say $6 a share, and return that share to the broker. So in this instance, the trader has sold the share for $10, bought it back again for $6 and has pocketed the difference of $4.
However, this is a gamble and in some cases the price can rise instead of fall. So in this example, instead of buying back for $6 a stock and pocketing the difference, the price of the stock has climbed to $15 a stock. For the trader the potential losses are limitless and at some point they have to buy back the stock in order to return it to the broker. At $15 a stock the loss to the trader will be $5, so they buy the stock back at this inflated price, take the loss of $5, and drive the value of the stock up even further by doing so. This is known as a short squeeze.
Why Did This Go Wrong For GameStop?
In the instance of GameStop this ‘short’ process was turned on its head when a Redditor on r/wallstreetbets noticed that a prominent hedge fund had taken a significant number of short trades against GameStop. The Redditor convinced a large number of people on the thread to collaborate in order to buy as much GameStop stock as possible in order to drive up the price of the stock.
One prominent hedge fund in question, Melvin Capital, required a multi-billion dollar bailout this week in order to survive.
Will Investors Holding GameStop Shares Profit?
Whilst the price has been forced higher by the Reddit crowd, holders of GameStop shares now need to sell those shares in order to lock in any profit. However, in this instance, where investors know the price has been forcibly increased beyond the actual value of the company’s fundamentals, this could prove difficult.
UPDATE: At the time of writing, retail investors around the world, including those in the UK are experiencing restricted trading on so called “meme” stocks like GameStop (GME) amongst others. In effect this means that investors can only make limited trades – in some cases just one – on investment platforms like Trading212 and Freetrade, which is why we created a list of the top 5 alternatives to Trading212 which should help investors make informed choices of where they can buy stocks like GME without restrictions.
Antonia is the Financial Editor at InvestingReviews.co.uk and brings a wealth of experience, having written for various industries over the past 10 years.
Her investment platform reviews, news, blogs and guides are meticulously researched, fact checked, and updated on a regular basis.