Hedge-Funds and Reddit: How Did GameStop Shares Cause Mayhem on Wall Street?

How did a group of Redditors make nearly bankrupt GameStop stock soar by 1700 percent on the stock market? What happened next and why does it matter?

Like many bricks-and-mortar videogame stores, GameStop was on the slow decline into bankruptcy until a few weeks ago. Yet, as of 27th January 2021, the struggling videogame retailer’s stock reached a meteoric, all-time high of over US$350. This unforeseen turn of events led to chaos on Wall Street and cost several hedge funds millions of dollars. To make the story even more insane, all of this was driven by a group of users on Reddit, ordinary people like you and me. But, how?

What has happened so far?

With the growth of digital downloads and a number of unsuccessful business decisions on the part of GameStop, the future was not looking rosy for the retail chain. In the past year alone, the company’s stock plummeted by over 60 percent as it reshuffled its executive staff. Video game and digital media analyst Michael Pachter told Business Insider:

“Downloads became a thing, and GameStop’s business declined.”

Institutional investors, such as the hedge fund investment firms Citron Research and Melvin Capital, saw an opportunity to take advantage of GameStop’s poor-performing stock (trading as ticker: GME) by betting against it. Stock that is not yet owned is sold, or “borrowed”. Eventually, this stock must actually be bought (or “closed”) in order to return them to the seller’s broker. The ultimate aim is to sell the stock high then buy it back at a lower price in order to profit. This practice is known as short selling.

Short selling has brought much controversy in recent years by causing share prices to be driven down. In the case of GME, the two hedge funds drove share prices from US$50 in 2013 to less than $10 at the start of 2021.

How is Reddit involved?

A community of users on Reddit, r/wallstreetbets, noticed that both Citron Research and Melvin Capital had sold short about 140 percent of available shares. Once it was discovered that these hedge funds had shorted GameStop shares by an outrageous amount, the Reddit users decided to buy every share of GME they could, thus driving up the price. Not only would they make money if the company could recover, the hedge funds were then forced to buy back the shares at much higher prices causing losses in the millions of dollars.

In an open letter to the subreddit, that has since received over 142k upvotes, u/ssauronn provided an explanation for why this was an important move on the part of the community:

“You’re a firm who makes money off of exploiting a company and manipulating markets and media to your advantage. Your continued existence is a sharp reminder that the ones in charge of so much hardship during the ’08 crisis were not punished.”

Many high profile names weighed in on the unfolding events, showing little sympathy for the traders of Wall Street. Alexandria Ocasio-Cortez tweeted:

Whereas, Elon Must kept his tweet shorter and too the point:

What happened to Reddit next?

As the media latched onto the David and Goliath story, Reddit’s r/wallstreetbets saw record-breaking traffic leading to about 74 million page views in 24 hours. To put that into context, Reddit itself has on average 52 million active users on a daily basis.

SEC regulators were also watching the story play out with interest. And, although institutional investors and Wall Street stockbrokers were loud in their calls for intervention from the SEC, no signs of market manipulation was found. Telling people you intend to purchase a certain stock and advising them to do so also is not illegal.

The Securities and Exchange Commission headquarters. Photographer: Joshua Roberts/Bloomberg

When a group of ordinary people on a social media platform can make such waves in the closed-ranks of Wall Street, it makes big news. Perhaps the WallStreetBets community moderator, u/bawse1, put it best when he addressed the backlash in a recent post:

“What I think is happening is that you guys are making such an impact that these fat cats are worried that they have to get up and put in work to earn a living.”

Is the saga over?

After hedge funds took a huge loss, they were left licking their wounds wondering how they could be out-manoeuvred by a group of amateur investors on Reddit. On Tuesday 26th January, GameStop was the most traded stock in the world. By Wednesday, they hit their meteoric high.

However, on the morning of Thursday 28th January, everything changed. Robinhood, a stock trading app favoured by amateurs, suspended the trading of GameStop stock citing extreme volatility. This essentially cut out all amateur investors from the market, with professional hedge funds able to continue trading. Stock prices took a tumble.

One user on Reddit, immediately filed a class-action lawsuit against Robinhood, claiming they “rigged the market against its customers”. True to form, users created a new subreddit, r/ClassActionRobinHood, to coordinate efforts. By Thursday night, Robinhood relented and allowed “limited” buys of GameStop stock. Despite prices taking a dive the day before, the stock opened on Friday morning up 100 percent.

Courtesy of Google

So, what now?

As of Tuesday 2nd February, the GameStop share price had dropped 63 percent, a far cry from the previous week’s 1700 percent surge. “GameStop shares will return to $10 sooner or later once this mania has subsided,” said Neil Wilson, chief market analyst for Markets.com. Jordan Belfort, the real Wolf of Wall Street, warned:

Jordan Belfort

“You must be so careful because eventually these stocks are going to come crashing back down to earth. If you are looking at this as a way to make your living, you’ll have to catch a falling knife on the way down. I would urge people to take their chips off the table.”

It seems inevitable that the price of these types of stocks will eventually return to relative normality once the frenzy buying has subsided. Because these surges are usually quite short lived, real money can be lost by ordinary people if not careful.

However, this was about more than amateurs noticing cheap stocks and trying to make money. People globally are fed up with a monopoly held over the economy’s value by Wall Street. As u/ssauronn rounded out his open letter on r/wallstreetbets, he noted:

“Whether you’re here for the gains, to stick it to the man as I am, or just to be part of a potentially market changing movement – thank you. Each and every one of you are the reason that we have this chance. I’ve never felt this optimistic about the future before.”

So as long as people are not being irresponsible with their money, this grassroots movement seems to be focused on taking Wall Street down a peg or two. The main goal seems to be an attempt to encourage the wealth distribution from the rich to the poor, a cause many can get behind.

Images courtesy of Getty Images unless otherwise stated.