Last week, the markets saw significant volatility ending with a loss to close out January. Given the news and the questions we gotten from clients, I thought that I would explain the Game Stop frenzy today.
First, some basic fundamentals. A share of stock is an ownership stake in a company. A small, privately held company might have a few hundred shares outstanding, so even four or five shares could represent a significant ownership in that company. Apple, on the other hand, has over 17 billion shares outstanding. Owning a few shares of Apple doesn’t represent a large amount of ownership.
When you own stock, you usually hold it with a brokerage firm or custodian. Most of the time, those stocks are held in street name. It’s the equivalent of your money in the bank. The bank doesn’t hold your money in a box in the vault for you. It lends that money out to earn interest on it. If there is a run on the bank, FDIC insurance steps in and makes you whole. They have 99 years to do that, by the way.
Most brokerage firms do the same thing with your securities. They can lend them out, or pledge them as collateral for loans. If they go under, there is insurance called SIPC, Securities Investor Protection Corporation, to protect investors.
Then we have short sales. A short sale is a bet that a stock will drop in price. A trader will borrow a share of stock from a broker and sell that stock. He’s betting that, before he has to return the share he borrowed, the price will drop and he can buy a share to return at the lower price. For example, a trader thinks Cogswell Cogs stock is overpriced. He’ll borrow 50 shares from a broker and sell them at $100 a share, the current value. A few weeks later, the price has dropped and he buys 50 shares at $80 a share. He returns those new shares, and pockets $20 a share in profits.
Sounds like easy money, right? But what if they were wrong about Cogswell Cogs? They announce a new widget and the price soars to $150. That trader now has to buy shares at the higher price, losing $50 a share. With a short sale, your loss is theoretically unlimited.
Enter GameStop, Reddit, and an army of retail investors. A hedge fund, or a group of investors who often take large risks in the hopes of realizing big gains, thought Game Stop was overvalued. The company was already struggling before the pandemic, when the shutdown shuttered many of their stores and cut revenue. The hedge fund short-sold the stock, betting the price would continue to drop.
A financial representative who holds the Chartered Financial Analyst designation and goes by the YouTube persona RoaringKitty began posting on Reddit that the stock was undervalued – worth more than it was trading for. He had researched the short positions the hedge funds held on Game Stop, and created what is known as a short squeeze, when the price of a stock that is shorted begins to rise.
As retail investors bought into his theory that Game Stop was more valuable than its current price, they began buying shares. This drove up the price, creating more buying as others followed the crowd – and the bubble. The hedge funds had no choice but to pay the inflated prices so that they could return the borrowed shares.
Now, like most bubbles, if you bought in early and then sold, you could have made a nice profit. But if you held onto those shares, or bought at the top, you could lose a large amount. Several of the new, online, low- or no-cost trading platforms temporarily suspended trading in GameStop, and a few other stocks that were experiencing a similar frenzy. Some have argued this was done to thwart retail investors and protect the hedge funds. It’s important to note that it was individual brokerages and not the stock exchange itself that limited trading. Robinhood has regulatory requirements to meet around capital obligations and deposits, and the trading frenzy was pushing against those limits. The stock could still be bought and sold on the exchange itself.
I’d like to point out that almost all of this was not investing, it was gambling. People saw the price of the stock going up, and wanted in on the action. They didn’t stop to look at the company they were buying. Is Game Stop a good company to own, that is going to increase in value, and return profits to owners? When all the frenzy stops, many small investors who didn’t understand all the fundamentals, will be left holding the bag. Sure, a couple of hedge funds lost big – as in billions. But other professional managers shorted the stock at the inflated high, and folks like RoaringKitty, who orchestrated the short squeeze, took their profits as well.
This week’s action to take is to call your credit card companies and ask for a lower rate. It’s not always going to work, but what do you have to lose? Sometimes, if your payments have been on time and you have a good credit history, they may be willing to lower rates.
If you want to learn more about all things financial, we host regular educational events. You can register for these, and find much more on our website at covingtonalsina.com, or visit our Facebook page to learn more.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. CovingtonAlsina and Great Valley Advisor Group are separate entities from LPL Financial.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The opinions voiced in this show are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investment(s) may be appropriate for you, consult with your attorney, accountant, and financial advisor or tax advisor prior to investing.