How to turn $50k into $50mil: The Gamestop Short Squeeze

Written and designed by: Shervonn Tan Le Xuan (23-E6)

How exactly did a ‘regular’ financial analyst and a group of investors on Reddit multiply their money seemingly overnight, making obscene amounts of money that would take the regular working class years to acquire? Could it really have been that easy? Let’s explore how Keith Gill, a regular financial analyst, turned his 50k investment into stocks valued at as much as $50million.

Long story short: He exploited major firms' practices of short selling. Their loss = his gain. Now, what exactly is short selling? 

Short selling (Simplified ver!)

According to investopedia, short selling is ‘an investment or trading strategy speculating a stock's decline’. Essentially, short selling is an investment in failure. Confused? Here’s the version for rookies! 

Assume all strawberries used in this scenario are homogenous.

The value of strawberries in the market now appears to be low, as strawberries are decreasing in popularity due to the rising demand for peaches. 

Seeing the decline in prices of strawberries due to its decreasing popularity, I borrowed 5 strawberries from you, promising to return them later. I then sell the 5 strawberries for $10; with the intention to buy it back at a lower price. When it’s time to return the strawberries, assuming that I have accurately predicted that the price of strawberries will continue to drop in the future, I buy back 5 strawberries for $5,  returning them to you. The profit of $10 - $5 = $5 comes from the principle of selling high and buying low, and is contingent on the bet that strawberry prices will decline in the future. 

However, if predicted wrongly, and strawberry prices instead increase to $15, my loss would be $15 - $10 = $5. Short selling is built on the principle that I have only borrowed the strawberries; I must buy them back to return, regardless of the prices. Thus, I gain profits when prices drop, and incur a loss when prices increase. 

Short selling is widely taken to be an advanced strategy that should only be undertaken by experienced traders and investors, due to the inherent risks it possesses and the sheer market analytical abilities needed. 

In the context of Gamestop

Similarly, in the Gamestop 2021 saga, many big Hedge Fund investors (me) made the prediction that Gamestop stocks (strawberry prices) would continue plummeting in value. This is largely due to the shift to digital gaming, making GameStop increasingly obsolete as a brick-and-mortar retailer. The hedge funds thus engaged in the practice of short selling, hoping to profit off the continual price drop. 

Enter Keith Gill, known as u/deepfuckingvalue on Reddit, who also had an active YouTube account since 2015, where he shared his routine of tracking stocks and researching investments.

Over-shorted?

Keith Gill stated that he bought the stocks simply because he liked it and thought it was ‘dramatically undervalued’, having bought GameStop stock for months before this surge. He then shared this information with his followers on his social media accounts, claiming that he thought it was over-shorted ie. There are more strawberries borrowed and sold than actually available in the market. So, being "overshorted" essentially means that there's a shortage of the stock being borrowed, leading to increased difficulty and higher costs for short sellers to buy back the stock. 

Short interest 

Short interest refers to the total number of shares of a stock that have been sold short (borrowed and sold) and remain outstanding (i.e., not yet bought back to close the position). These shares are technically still “borrowed” from other investors, such as institutional or retail shareholders, who own them. Estimates suggest that by January 2021, the short-interest has skyrocketed to 140% of the public float. By January 2021, the short interest of some stocks, like GameStop (GME), was reported to have exceeded 100% of the public float. This situation arises due to rehypothecation—borrowed shares can be lent out again, leading to more shares being shorted than exist in the public float. To make it easier to digest, imagine there are only 100 concert tickets available for a show, but scalpers somehow manage to sell 140 tickets. This happens because the same tickets are being “borrowed” and resold multiple times, creating more promises to deliver tickets than the actual tickets available. If everyone who holds these promises shows up demanding their tickets, chaos ensues—just like when short sellers rush to buy back shares, creating a short squeeze.

Hedge funds shorted the stock so much, way more than the actual shares available; meaning that a small price increase could trigger a short squeeze. A short squeeze refers to a rapid increase in the price of a stock owing primarily to an excess short selling of said stock. To understand this, fall back on the basic principles of demand and supply— when supply remains the same but demand rises rapidly, so does price.

Realising a potential overshort, many people, mainly consisting of redditors from r/wallstreetbets, a subreddit Gill frequented collectively purchased Gamestop stocks, believing that they could collectively push the stock price higher by buying and holding the stock. Essentially, this would force the short sellers to cover their positions by buying the stock at higher prices to limit their losses as prices continue surging. This attracted the attention of several other institutional investors who also piled in on GameStop, further fuelling the surge. 

Remember the deal made by me earlier to return the strawberries? Similarly, in this context, the short sellers started scrambling, hoping to buy back the stocks that must be returned before the prices shoot even higher, so that their loss incurred will not be too large. 

This is where the term “diamond hands” came into play. When investors realised that demand would continue to rise due to short sellers' desperate attempts to buy back their stocks and reduce their loss, they decided to hold onto the stocks longer. With insufficient supply in the market and high demand, the stock prices continued increasing rapidly.

The Wall Street short sellers got caught in this short squeeze as they have been forced to buy in at higher and higher prices to cover their bets, incurring larger and larger losses. 

Immediate impacts

Adding more fuel to the fire, certain trading platforms such as Robin notoriously restricted or limited the buying of Gamestop stocks in order to protect the Wall Street investors who are suffering losses. This made the GameStop saga more frenzied as this action sparked a furore among retail investors. They believed that the restrictions were unfairly implemented to protect the interests of Wall Street investors, to curb their losses. Additionally, some saw it as a breach of trust by the trading platforms that purported to provide access to the markets for all investors.

This situation quickly gained widespread media coverage, attracting even more attention from retail investors and the general public. 

According to Forbes, at its peak, Gamestop stock was valued at more than $400 per share, in January 2021, in comparison to the $20 per share in late 2020. Thus, Gill’s stocks which he bought at 50k, shot up to a value of $50million. 

Sooo.. How did the saga end?

The GameStop short squeeze ignited debates about market regulation, and Gill even had to testify in front of Congress about his role in the saga, defending his role as a mere individual investor who had the right to freely express his opinions on the stocks in social media. Class action lawsuits were filed accusing  him of violating securities laws by inciting the GameStop rally, though they were eventually dismissed. 

Hedge Fund Companies

As for the hedge fund companies who suffered losses, most of them did not turn out as fortunate. Most notably, Melvin Capital required a $3 billion bailout; but by May 2022, announced its closure as it could not recover from its financial losses.

Implications; how it changed our views on the stock market

This short squeeze highlighted the inherent flaws in the market. Many realised that the value of a stock, though strongly correlated, isn’t rooted in its projected success or potential. Rather, it is determined by the amount an individual is willing to pay for it, by the principles of supply and demand. This short squeeze also reinforced the dangers of short selling, as the losses could be infinite. Traditionally, if a stock has been bought for say, $5000, the maximum amount that an individual has to lose is $5000 if the value of the stock plummets to 0. However, with short selling, as the stock is borrowed and has to be bought back no matter the price, there is essentially no loss limit. 

Additionally, this act challenged traditional Wall Street practices through social media platforms like Reddit, subverting the power they held as people realised that even the largest, most influential financial firms were susceptible to losses, and even collapse. 

Conclusion

Besides stocks in the financial market, it is interesting how even currencies can also be subject to overshorting. One notable example is the British pound’s “Black Wednesday” crisis in 1992. Speculators, led by George Soros, heavily shorted the pound, betting it would fall below its fixed exchange rate within the European Exchange Rate Mechanism (ERM). Their actions created immense pressure on the currency, ultimately forcing the UK to withdraw from the ERM. More spectacularly, Soros himself walked away with $1 billion from his short position against the pound, seemingly overnight. In the end, a short squeeze, particularly Gamestop’s, shows how everyday investors could take on Wall Street and win, at least for a moment. It was a powerful example of what can happen when people come together, while also revealing just how risky and subject to manipulation the stock market can be.