...Of GameStop,Robinhood And The Tech Regulation Conversation: (Part 1)

 If you have been on Twitter over this past week you would have probably seen the words GameStop, shorts, hedge funds, Robinhood quite a lot. To provide context for this blog post here is a very high-level description of what happened with regards to the aforementioned words. Much more detailed descriptions of the situation can be found all over the internet, including this brilliant thread on Twitter.

Basically, a bunch of really rich dudes (the hedge funds) had decided to bet against the stock of GameStop, a physical video games retailer. The reasons for betting against GameStop are quite logical. I mean, first of all, who still buys video games from mall shops when you can just download them off the internet right? Secondly, we are in the middle of a pandemic that is going to change how we do things hereon. Physical video game stores are one of the many things which are likely to be left behind by humanity even after the pandemic as we march on with digitalization, right?

Betting against a stock is referred to as "shorting" that stock. Here is how it works, again a very high-level explanation. Normally, when you invest in stocks, the golden rule is to "buy low and sell high". This means, you buy a particular stock when its price is low and hope that its price will increase with time, after which you sell the stock at that higher price and enjoy the profit, being the difference between the price you bought and the price you sold the stock. Shorting works in the opposite of this logic.

When you short a stock, instead of hoping that its price will go up in value, you hope that it instead goes down in value. Here is why. When you short, you "borrow" stock from a broker and immediately sell it to the market at the price you "borrowed" it at. After selling that stock, you wait for its price to go down, and after it does, you buy it back from the market at that lower price and return it to the broker, pocketing the difference in the process.

To clarify the concept further, here is an example. Let's say that Company X's stock is currently valued at $40/share. But Company X is currently going through a bad business period so the signs point to its stock price plummeting as more people sell their holdings of the company's shares. To short Company X, you approach a broker, "borrow" maybe 400 shares of Company X's stock, and sell it into the market for a total of (400 * $40 = $16 000).

Now you have $16 000 in cash but you still owe the broker their 400 shares of Company X stock which are valued at $40 /share. So in short (pun totally not intended), your margin is $0. Now, as you had predicted, Company X's share price starts tumbling down and eventually gets to as low as say $5/share. So you as the short seller decide to return back the shares you "borrowed" from the broker but the good news for you is that the share price is now $5/share and no longer $40/share. So you buy back the 400 Company X shares at $5 each and return them to the broker. You spend a total of (400 * $5 = $2000). Your profit becomes the $16 000 you sold the borrowed stock minus the $2000 you bought back the stock for. That's a nice $14 000 in your pocket.

The rich dudes were planning on doing precisely the same with the GameStop stock but alas, another bunch of dudes on Reddit discovered the plot and were like, "not gon happen." Why were they against this plot by the rich dudes? Well, for several reasons. Firstly, short selling is unethical. You are betting for a company to fail, costing jobs in the process and severely affecting livelihoods. Secondly, as Elon Musk concurs, shorting is just a legal form of market manipulation. If I cannot sell a car or a house I have borrowed and don't own, how come rich dudes can sell stock they do not own but have merely borrowed? Very unfair.

Unhappy with this, the Reddit dudes started countering the hedge funds by buying the GameStop stock and encouraging others to also do the same. The domino effect had started. What happens when more and more people buy a particular stock? Well as a response to the increasing demand, the share price starts going up and up. That is what happened with the GameStop share price. But wait, what about the rich dudes who had bet on the share price going down? Well, they have a problem.

Remember that they still have to return the "borrowed" GameStop stock they sold into the market, but as the share price goes up, their margins now go into the negatives. For example, if they had borrowed 1 share of GameStop at $40 and it shoots up to $60, they have to buy it back at $60 and return it to the broker. That is a -20$ loss. Now imagine the same scenario but instead of 1 share, they have "borrowed" millions of shares which they now have to buy back at a higher price. The potential losses multiply very quickly. This creates what is called a "short squeeze". 

So how do the rich dudes try to get out of this short squeeze and minimize losses? Well, by buying back the stock and returning it to the broker before the price gets even higher and their losses multiply even more. But by doing this, they create what is called a "feedback loop". The more the rich dudes buy back the GameStop stock to return it back to the brokers, the more they increase its demand and hence its share price. So that is(well one of the reasons) how we got to a point where the GameStop share price rose from $77/share on the 25th of January to $325/share today on the 31st of January, a 422% increase in a mere 5 days.

PS: In Part 2, I will be discussing how Robinhood, the "free" stock trading app, fits into this whole saga. Subscribe to get it straight in your email inbox!