Business as Usual: The Completely Predictable GameStop Short Squeeze

Richard Falvo, Staff Writer

It is not too often that a finance-related event takes center stage on virtually every major media outlet across the globe. This is why resources such as The Financial Times and Bloomberg exist: to provide a constant stream of information pertaining to the global financial markets. However, to someone not familiar with the complexities of finance, such a nonstop feed could easily become overwhelming. As a result, it is only on occasion that conventional news outlets incorporate finance into their lineup.

Well, this very occasion took place just a couple of weeks ago, as shares of distressed video game retailer GameStop (GME) caught most of the public, including some of the biggest financial institutions, off guard following a meteoric rise over a very short period of time. As the event unraveled, many public figures were quick to assert the unlikelihood and unpredictability of such a scenario taking place. In reality, this could not be further from the truth. If analyzed properly, the GameStop short squeeze could be seen coming from a mile away. In fact, if you have been following this column for a long enough time, you will remember an article I published in 2019 that laid out the potential for the very episode that took place. The rest of this piece will look back at that article, as well as dive a little deeper into why GME was uniquely positioned for its wild ride.

Since the early 2010s, the global economy has become increasingly dependent on services and faster turnaround times. As the decade progressed, consumers demanded higher quality products, decreased wait times for those products and a more efficient market altogether. While these demands produced seemingly limitless opportunities for start-ups and trend-oriented businesses, they also posed a major threat for firms that rely on conventional mediums of delivery, such as brick-and-mortar retail. Being a company that relies heavily on foot traffic into its stores, as well as the sale of physical video game discs, GameStop was dealt with a double-edged sword. With the explosion of e-commerce and the advent of mobile gaming, the company’s business model quickly began to disintegrate.

Unfortunately for GameStop, it was unable to adapt to these changing market conditions, and its stock price suffered immensely. From November 2015 to July 2019, shares of GME fell more than 91%, as short-sellers (those who believe a stock price will decline) poured in. As a result, the short interest — the ratio of shares shorted to shares available for trading — on GME began to rise. In mid-2018, roughly 40% of available shares in the company were being shorted, according to data from Bloomberg. While a relatively large value in and of itself, this short interest would soon be dwarfed, as large institutional investors began to get in on the fun. Before long, the short interest on GME had ballooned to over 100%. Now, if you are wondering, “How is it possible for the number of shares being shorted on GameStop to be greater than the number of shares available for trading?” you are not alone!

I happened to ask myself that very question after coming across GameStop in 2019 and arrived at the following unpopular conclusion: the stock is being artificially driven down by large investors taking part in naked short selling. Therefore, “a recovery in the foundation of GameStop’s business model and execution would result in an enormous short squeeze, which in turn would lead to massive gains in the price of its stock,” per the article published by The Colgate Maroon-News in October 2019. For those not familiar with the term, “naked short selling” is the practice of shorting a stock without initially borrowing it from someone, or even ensuring that it is a security that can be borrowed. When shorting a stock, an investor must first borrow shares from someone who owns them. After borrowing those shares, the investor immediately sells them on the market with the hope of buying them back at a lower price to return to the original owner for a profit. In the case of GameStop, large institutional investors took part in the illegal yet easily navigable act of naked short selling, thus allowing the short interest of the stock to exceed 100%. As long as a sudden burst of buying did not occur, the stock price would remain low.

But, after a popular thread on Reddit, an online forum spanning across a variety of topics, picked up on the irrationally high short interest of GME (around 120% in January 2021), a flurry of buyers began to enter the market simultaneously. This dramatic burst in demand sent the stock price soaring. Due to this rapid rise, institutional investors who had shorted the stock beyond its means were forced to cut their losses by purchasing their “borrowed” shares back on the open market. However, this just caused the price of the stock to rise further (an increase in demand causes an asset to increase in valuer). This phenomenon is known as a “short squeeze.” At its peak on January 28, GME reached a price of $467.19, an increase of 7,647.76% from its closing price on the day my initial article was published.

Shares of GME have since fallen significantly from peak levels reached during the short squeeze; however, the takeaway from this article should be that its meteoric rise should not have been considered surprising. Far too many investors neglected the underlying business of GameStop and instead resorted to ruthlessly shorting the stock based solely on the fact that it was popular and profitable. However, the trade became overcrowded and burned the very people who put it into motion. Melvin Capital, a hedge fund with over $12 billion in assets under management, lost over 50% in January alone thanks to the GameStop fiasco.

After reporting on the Great Financial Crisis of 2008, author Michael Lewis published one of his most famous books, The Big Short. The book, which was later developed into a major motion picture, tells the story of a few obscure investors who saw the crisis coming well before it arrived. Though initially ridiculed and mocked for their loom-and-doom predictions, the investors were eventually proven right and profited handsomely in the process. After the events of the past two weeks, I have come up with a sequel for Lewis’ book: The Big Short Squeeze.