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What's going on with Gamestop: a simple explanation

Standard disclaimer: this is not financial advice. I'm just some guy. What I say here is massively oversimplified, and there's many parts of it that I don't fully understand. If you have any corrections to what I say below, please let me know.

So, it all started when some hedge funds borrowed some stock that wasn't theirs, and sold it for a quick buck.

"Wait, that's allowed?"

Yes. It's called "short selling", and it's not even the most ridiculous part of the story. Read on.

They did this so much, that they borrowed more than all the stock that was available on the market.

"Wait, THAT'S allowed? And how is that even possible?"

Yes, it's allowed. And it's possible, because they sometimes borrowed the same stock more than once. Meaning, they borrowed a stock, sold it, then borrowed it back, and sold it again. In the end, the number of stocks they borrowed was around 130% of the total number floating around in the market.

"Okay, but the stock was only borrowed, right? So it has to be returned eventually?

Yes. The stock has to be returned, so the hedge funds have to buy them back eventually. But they weren't too worried, because the stock was for Gamestop, which they thought was a bad company whose stock was going to decrease in value. So their plan was to buy it back cheap when they had to return it.

But some investors on reddit, on r/wallstreetbets, got a wind of this situation.

"So what did they do?"

They liked the stock, because they thought Gamestop wasn't such a bad company. They also saw that the hedge funds HAD to buy back a ton of stock eventually, which would increase its future demand. So, they decided to buy up as much as possible.

"What happened then?"

Their massive buy-in caused a corresponding increase in the stock price. On top of that, the hedge funds were running around trying to buy back the stock, because they had to return what they borrowed. This is called a short squeeze, and it can cause the price of the stock to increase dramatically.

And remember, these hedge funds borrowed more stock than the total amount available in the market. Meaning, they'd have to buy back the same stock twice, just like they had initially sold the same stock twice. Imagine having to doing that: you go to a stockholder, and beg him to sell it to you at an inflated price. After you finally buy it, you return it back to him, then beg him AGAIN to sell it to you a SECOND time, probably at an even higher price.

"But how could the stock for Gamestop be worth so much? Fundamentally, isn't it just a small, struggling company?

That's right. Based just on the business fundamentals, the stock is probably only worth about $20. But there's a huge additional value, coming from the fact that these hedge funds are legally required to buy up every available stock, and then some more. At that point, it doesn't matter what the "stock" is. Any commodity, no matter how worthless, will increase in value under these conditions.

"But isn't this just a bubble? A pyramid scheme? A pump-and-dump?"

Not quite. There is real solid demand underneath it, in the form of those hedge funds that have to buy back the stock. They're legally required to return what they borrowed. That's about as real as it gets.

But yeah, a lot of it is just people piling on to a skyrocketing stock. So that part is like a bubble.

"So people are piling on?"

Oh, absolutely. This first started as just some market maneuvering around a rising stock, but quickly became much more. It became a story of David vs. Goliath, of little individual investors taking on the big hedge funds. It attracted an international audience and became mainstream news. People spoke of taking on the corrupt financial systems, and discussed the powers and dangers of social media like reddit. Politicians and industry titans got involved. All this attention brought on new stock buyers, driving its price even higher.

"So the hedge funds are just gonna have to pay out and buy these high-priced stocks?"

They're trying very, very hard not to. They want to bring down the price by any means necessary. Some of their tactics may have been incredibly shady: the stock trading app Robinhood restricted people from buying (but not selling) shares of Gamestop, which caused a huge uproar. Many suspected market manipulation, and there's lawsuits flying around.

The hedge funds are also delaying the return of these stocks, by just re-borrowing them again. But borrowing isn't free: they have to pay interest to borrow, which is going to be expensive because the stocks are expensive. Still, they're hoping to delay the actual, permanent returning of the stocks until the prices go back down.

So as of right now (2021-01-28), it's kinda like a game of chicken between the hedge funds and the individual investors on reddit. The hedge funds want to delay buying the stock, while doing everything possible to make the price drop. They lose by giving in, accepting their losses, and buying the high-priced stocks. This will drive the price even higher, because of the sheer volume of the stock they have to buy back. For the reddit investors, that's the outcome they want. They lose by selling out earlier, which would drive the price down and let the hedge funds off easily.

"So how will this all end?"

Nobody knows for sure, of course. But it can't go on forever. As the prices continue to increase, the hedge funds are more likely to just accept that they have to buy, because they can't delay forever. The redditors, too, will become more tempted to sell at the higher prices. So, I do think that the "short squeeze" will work to some extent, and there will be a net transfer of wealth from the hedge funds to the redditors. And after a furry of sales, the price will eventually drop back down to the neighborhood of $20.

Make no mistake: some people will buy in at the very top, and lose a lot of money when the price drops. In fact, I think this is probably the likeliest outcome for any individual investor. So it's risky, in that lots of people are going to lose a lot of money. But it's also sensible, in that on average, if you get in cheap enough, you'll be taking some real money from the hedge funds. It's a strange gamble.

"Where do you fit in all this?"

In the interest of full disclosure, I'll say that I hold a decent amount of Gamestop stocks, but also some long-term put options. This is in accordance with what I think will happen, as I described above. And for these stocks, I have no illusions about it being a sure bet that'll go to the moon. I recognize that there's a very good chance that I'll lose most of it, but I do think that overall, the net expectation value is positive.

But in any case, the next week or so will be very interesting, and this story will be one for the history books.

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