Social media was suddenly flooded with financial experts last week after GameStop’s stock price rose dramatically. Many people (myself included) have gotten lost in the scramble to figure out what’s going on. Here’s an explainer of some of the basics of what’s happening, and what might happen in the future:
What is a hedge fund?
To begin, let’s first define what a hedge fund is. A hedge fund takes money from their clients and makes risky investments to make profit. Like mutual funds, fund managers do the research and make the decisions for their clients. Unlike mutual funds, they can take bigger risks because they aren’t as heavily regulated by the SEC. Only “accredited investors,” which include people of a high income level or net-worth, can invest in hedge funds.
What does it mean to “short” a stock?
One strategy that hedge funds use is to “short sell” a stock. Someone borrows a stock and immediately sells it, knowing that they will have to buy it back. If that stock’s price drops, then they get to buy it back cheaper then they sold it, giving them a profit.
Basically, short sellers are taking bets on a stock’s price falling. That can be risky because they have to buy back their shares no matter what by a certain deadline. If that stock’s price actually rises, they can end up losing more money than they put in.
When short sellers are forced to buy back their share while it’s rising, the price will rise even more as a result. This is called a “short squeeze.”
So, how did this all start?
Some hedge funds started borrowing GameStop stock (GME) to short it, assuming that it was overvalued and would be going down. They got a little bit too excited, and ended up borrowing more shares than there actually were.
Some users on r/WallStreetBets, a Reddit community that treats trading like gambling, noticed that this was going on. They realized they could start buying shares, drive GME’s price up, and eventually force the hedge funds to buy back the shares at the new ridiculously high price.
Some hedge funds took on huge losses, or got bailed out by other hedge funds. Others doubled down and continued to short the stock, hoping that it would crash and the price will fall back down.
But r/WallStreetBets users know that if they “hold the line” and refuse to sell, the price will stay high. More people started buying shares after some hedge fund managers went on cable news to complain about the situation, and it spread beyond Reddit to other social media platforms.
Why are people doing this?
Users on r/WallStreetBets largely want to force these hedge funds into bankruptcy. Some people have joined in on this “populist” movement to take down Wall Street. Some people are entirely willing to lose money–as long as it hurts hedge funds.
Others, however, want to make money. Some people were convinced to buy shares so they could sell them as the price rose, securing them a profit. Both groups are incentivized to convince other people to buy and hold, ensuring that the price keeps going up.
Many millionaires and billionaires have promoted the movement and invested to get back at hedge funds for shorting their stocks. For example, short sellers targeted Tesla in 2020, prompting Elon Musk to tweet about “gamestonk.”
What’s Robinhood got to do with it?
Robinhood is an app that allows users to trade stocks without a commission fee. It makes trading accessible to a larger, younger audience. It became increasingly popular throughout the pandemic by attracting people who would otherwise be betting on live sports.
The app has been criticized for making trading stocks feel like an addictive mobile game. Critics have also pointed out that Robinhood’s business model lacks transparency.
Robinhood restricted trading in GameStop on Thursday to not allow investors to buy GME shares, citing “recent volatility.” Other targeted stocks were also restricted.
This triggered backlash from r/WallStreetBets users and other retail investors who saw it as an attempt to manipulate the market on behalf of hedge funds like Citadel.
Robinhood’s CEO attempted to refute the claims as a “conspiracy theory.” Politicians like Sen. Ted Cruz and Rep. Alexandria Ocasio-Cortez have called for an investigation into Robinhood’s decision.
GME fell on Thursday but bounced back on Friday after some of the restrictions were eased. The SEC will review the restrictions by Robinhood and other brokers.
A user in a thread on r/AskReddit asked, “Brokers of Reddit, how crazy is it where you work/on the trade floor rn?”
“As much as young people on the internet like to imagine this as an epic, David vs Goliath, Wall Street vs Main Street showdown for the history books,” one user said in response. “From a bird’s eye view it’s actually just a brief dumpster fire where a couple hedge funds lost their shirts betting on one little small cap stock.”
Some hedge funds, like Melvin Capital, will lose out, but others, like Citadel, will profit off this. Some retail investors might be able to pay medical bills, but others might lose it all when it crashes.