Explained: GameStop vs Wall Street

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GameStop, a struggling US video game retailer which announced plans to shut 450 stores last year, has become the unlikely centre of a huge shake up in the US stock market.

The phenomenon has seen some Wall Street hedge funds, including prominent short seller Melvin Capital, lose billions of dollars and may yet cause funds to collapse entirely.

Stocks have remained at highs of $325 this morning (up from $17.25 at the start of January), despite many trading platforms controversially banning users from trading the stock, meaning the battle is far from over.

To try and make sense of exactly how a struggling retailer has seemingly cost financial professionals billions of dollars, we’ve broken down each of the market mechanics required to understand this unprecedented turn of events.

Short Selling

The stock market, in its most fundamental form, allows traders to purchase “stocks” or “shares” in a company. If the price of the stock goes up they can then sell their shares for a profit, while if the price goes down, they will lose money.

Short selling is a method which allows traders to turn this concept on its head, allowing them to make a profit when the price of a stock goes down. Hedge funds will often short the stock of a company they believe will soon see its share price collapse in order to make a profit.

By shorting a stock, the trader must essentially borrow or rent the shares from a brokerage firm. Instead of actually buying the shares, the trader is given a credit where the money is given to them at the current share price.

When the share price falls, the trader can then buy the shares from someone who actually owns them at a lower price. They then return the shares to the brokerage firm and keep the profits made on the difference.

Conversely if the stock price rises, the trader will have to pay the brokerage firm the difference.

This technique is often used by hedge funds to drive a company’s share price into the ground and force them into bankruptcy. If the share price hits $0 they keep their entire credit, and must only pay the brokerage firm interest on their loan.

This is exactly what firms have tried to do with GameStop, which has seemed on the doorstep of bankruptcy for some time.

Short Floats

The interest traders need to pay brokerage firms on the money they have borrowed while shorting a company depends on the percentage of shares in the open market, referred to as a “short float”.

When the number of shorted shares or short float reaches 100 per cent, there are no more shares in the open market available to borrow, therefore brokerage firms should technically stop traders from being able to buy them.

As the army of independent traders began to buy GameStop stock and drive up the price, the Hedge Funds responded by increasing their short credits with brokerage firms, assuming they could make even more when it collapsed.

This in turn, saw to them pay increased interest on their borrowed money, which they believed would be negligible compared to their profits when GameStop eventually went under.

As demand for short positions skyrocketed, the short float indeed maxed out at 100 per cent, however brokerage firms continued to sell short positions to hedge funds on shares which didn’t exist.

The practice, which is technically illegal, is referred to as “naked shorting”. Brokers stand to make money on the dramatically increased interest fees, while traders have such huge short bets that they’ll make considerable profits when the stock collapses.

Often when a share price skyrockets like GameStop’s has, short sellers will exit their positions, forcing them to buy the shares to exit and sending the share price even higher.

This has not happened in this case, and hedge funds have doubled down on their short positions.

Margin Call

When stock prices jump dramatically, as has been the case with GameStop, brokers can demand a “margin call” where they can force the short seller to return the shares regardless of their financial situation.

Traders must then either return their shares at the current price, or pay to keep their position and pay the interest.

Most firms would rather pay the interest on the credit and keep their position, hoping the price will eventually drop. If they can’t pay the interest, they’ll have to liquidate assets and gradually buy the shares, steadily coming out of their short position.

In this case however, the army of independent traders are refusing to sell their shares, meaning the Hedge Funds are unable to buy their way out of their short positions.

Effectively firms like Melvin Capital, which has so far lost nearly $8 billion, is stuck paying massive interest rates and has run out of capital to cover its position.

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