This article previously appeared on News@Northeastern. It was written by Molly Callahan.
Wall Street is in a tizzy over GameStop, a retailer that, by many accounts, was on its way out the door. But over the course of several days, a band of Reddit users and amateur day traders have swung the fortunes of the video game company in the opposite direction, driving the cost of its stock up by as much as 1,700 percent at one point.
So what’s happening? Jeffery A. Born, professor of finance and associate dean of undergraduate programs in the D’Amore-McKim School of Business, and his colleague, Keith Smith, assistant professor of marketing, agree that these are strange times, indeed.
Here’s what you need to know.
Q: How did GameStop get caught up in the stock market?
A: Until this week, the video game retailer most often found in malls was among many stores being edged out by online marketplaces. Sales at the company have been sluggish because gamers no longer need to visit a physical store to buy a new game; they can download new games from the comfort of their own homes.
Traditional investors saw this as an opportunity to make a financial bet against GameStop, using a move known as shorting, or short selling, the stock.
Q: What’s a short?
A: “Essentially, you can profit off bad news by selling stocks you don’t have—in the hopes that you’ll buy them back at a lower price and make a profit,” Born says.
To short a stock, a trader will instruct a broker to find a shareholder who is willing to lend the trader their stocks, with the agreement that the trader will return them later. The trader can then turn around and sell those borrowed stocks to someone else. If the stocks drop in value, the trader can buy them back at a lower price before returning them to the original owner.
The trader, essentially a middleman in this scenario, can pocket all the profit made from selling the stocks at a high price and buying them back for less.
“We know the way to make money on the stock market is to ‘buy low, sell high,’” Born says, “but you can do that in either order, and shorting is the backwards one.”
Shorting a stock is risky, though. Traders who short are betting that the price of their borrowed stocks will fall so they can reap a profit. But it’s also possible that the price of the stocks will increase, putting them in the hole when it comes time to buy back their borrowed stocks and return them. And while there’s a limit to how low the price of a stock can drop—$0—there’s almost no limit to how high it can climb.
Q: Where does Reddit fit into this?
A: With every indication that GameStop was steadily losing value, a huge amount of its shares had been sold short, Born says.
In a typical worst-case scenario, 5 to 10 percent of a company’s stock is shorted, he says. But with GameStop, more than 100 percent of its outstanding shares had been borrowed and sold.
“The amount of short-selling was probably higher than any other circumstance that I can remember, and I’ve been watching the stock market for 52 years,” Born says.
Hedge funds and capital management funds had made huge bets against the company, expecting the value of its stock to keep falling. Here’s where Reddit users swooped in.
A community within the social network called /r/WallStreetBets, composed of amateur investors (also known as day traders or retail traders), had been keeping an eye on the companies for which a large portion of stock was shorted.
After all, shorting a stock means that buying it back has to take place at some point.
So, the Reddit investors coordinated their efforts to buy up huge swaths of original GameStop stock. Their goal was to drive up the price that the hedge fund crowd would have to pay to buy back and return their shorts. This is called a short squeeze.
To some extent, the plan worked: Financial data companies estimate that short-sellers lost upwards of $70 billion so far this year from GameStop and other companies in the Reddit crosshairs.
Q: What are the Reddit investors getting out of this?
A: That’s harder to pin down.
Some people are undoubtedly doing it to make a quick buck. And some news coverage, including that of The Associated Press, has described the saga as a modern day David and Goliath—in which the small army of Reddit investors battled it out against bigger, wealthier, more established hedge funds.
Smith, who studies the effect of social media on marketing, sees it this way, too.
“What we’re seeing in the Reddit space is very much a social identity phenomenon going on, where we have an in-group/out-group scenario,” he says.
Individual investors typically see themselves as people without a lot of power to control the stock market, Smith says; they just buy and sell as opportunities arise. Large investment companies, meanwhile, are seen as the ones influencing the market, Smith said.
“And there’s very much an oppositional attitude toward investors, a sense of ‘This is our chance to get back at them,’” he says.
Q: How will this end?
A: That’s also hard to say, but it’s clear that this bubble will burst at some point, Born says.
“There hasn’t been any actual change in the company. This is all very ephemeral,” he says. “It’s worrisome when prices are driven to places that have no real connection to the company underneath.”
Brokers on Thursday put the brakes on buying GameStop stock in an effort to cool down a hot, frothy market, and shares of the company’s stock fell more than 40 percent as a result.
Reddit users and the remaining short sellers were locked in a standoff, as Reddit investors encouraged each other to wait out the short sellers, who would have to cover their positions eventually.
The U.S. Securities and Exchange Commission also announced that it was “actively monitoring” volatility in the market to see if any players defied regulations.
And, as Born said, “Securities law is not something you want to get on the wrong side of. Let’s remember they sent Martha Stewart to jail.”