A customer holds a GameStop shopping bag inside a store in San Francisco.
David Paul Morris | Bloomberg | Getty Images
Wall Street has been watching GameStop with admiration as a bunch of retail investors obsessed with Reddit managed to raise the stock by 1,500% in two weeks, squeezing short selling hedge funds.
A wave of home traders met in Reddit’s fiery “wallstreetbets” chat room, whose members have grown to more than three million. By motivating each other to continue to accumulate stocks and call options, they coordinated a monstrous grip on the traditional video game retailer.
“Retail investors with the help of technology that acts as a union in the attack is a new phenomenon,” said Jim Paulsen, chief investment strategist at Leuthold Group.
“You combine the power of technology, which allows you, through Reddit posts, to expand your individual impact, with some use of leverage and very targeted bets, they can have a significant influence, especially in areas of vulnerability because of of short positions, “Paulsen said.
Many enthusiastic Reddit users have posted screenshots of their brokerage accounts, some of which announce astronomical returns of 1,000% in a few days. These passionate investors often call short sellers in the chat room with colorful language and nasty Internet memes.
“This is gaining cult status,” said Quincy Krosby, chief investment strategist at Prudential Financial. “It’s a package of merchants and the package is gaining momentum. The retail crowd is not only taking over the sold, but also the headlines.”
The intense speculative behavior among retail investors is unnerving many on Wall Street, as the increasing losses of hedge funds may spread to other areas of the market. Some also believe that this shopping frenzy could be a threatening signal for a record-breaking market.
“This could destabilize the general market and confidence in the market. Those who have not joined will be forced to join,” added Krosby.
These amateur investors began to target other heavily sold names, including AMC Entertainment and Bed Bath & Beyond, leaving the targets of Wall Street analysts in the dust.
How does short selling work?
A short seller borrows shares of a stock and sells them to buyers willing to pay the market price. As the stock price drops, the broker would buy back for less money, pocketing the difference.
However, when the stock rises dramatically, it forces short sellers to repurchase shares to limit their losses. The cover sold tends to further fuel the rise in the stock.
The GameStop demonstration was initially triggered on January 11, when news that Chewy activist investor and co-founder and former CEO Ryan Cohen is joining GameStop’s board. Shares jumped on the announcement in the hope that Cohen would drive a change in strategy.
GameStop continued to rise rapidly, as retail merchants showed no signs of abating. Amid heavy pressure, Melvin Capital closed its short position on GameStop on Tuesday afternoon after suffering a huge loss, the hedge fund manager told Andrew Ross Sorkin of CNBC. Short seller Andrew Left of Citron Research said on Wednesday that it covered most of its short position on GameStop at a loss.
GameStop was the most traded name in the US stock market on Tuesday, outpacing even megacap companies like Tesla and Apple, according to Deutsche Bank.
Options that overload the grip
Many avid Reddit posters advertising GameStop are buying call options, a type of derivative contract that gives the holder the right to buy the underlying security at a stated price within a specified period. The values of call option contracts can increase even more when the underlying stock is rising 100% in a single day. Option trading has become accessible and easy for millennial investors, thanks to these new, commission-free applications like Robinhood.
“This is all part of the democratization of the market,” said Krosby. “Usually, when we talk about leverage and options, this is usually associated with investors, professional managers and hedge funds.”
When retail investors look for positive and cheap call options, this leaves the seller or the market makers, who are the intermediaries in the transaction, with few positive call options, or short range. As stocks rise to these strikes, market makers need to buy more and more stocks to protect their put options. This effectively accelerated the rally further on GameStop and other heavily shortened names.
“The flow of retail orders in options is essentially overwhelming the short grip, like the tail wagging the dog,” said CC Lagator of Options AI. “This gamma effect adds buyer after buyer to the stock, without anyone being able to sell the stock because it is difficult to borrow. The effect is a massive squeeze on the sale.”
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