Buy GME? The GameStop Short Squeeze Explained

Many of my readers have been asking about the short squeeze that is happening right now, driving an unlikely stock through the roof. Do I get in now? Should I wait? Should I get out now?

Let’s me guess – you are here because you heard about this one stock that’s rocketing up and making people rich, yet bankrupting others. A social media group on the website Reddit seemingly led by a small few recognized a strange confluence of events. They coupled that with a desire to fight back against the hedge funds and leveraged the social media platform to drive the stock up, making a few rich, and causing panic in the hedge funds. Let’s take a step back and recall what brought us to this crazy time.

The GameStop Perfect Storm

GameStop is a company who for years thrived off the business model of buying back game CDs for pennies on the dollar and reselling them to other customers for a profit. Some of their hard sales tactics were called into question. This was a company that gamers loved to hate and many rejoiced when its stock (NYSE:GME) bottomed out at $2.57 a share. Those who bought GME in 2008 for $60.00 would have taken a huge loss had they sold in 2020.

Bad publicity, customer revolt, and hard sell tactics contributed to a feeling that GME was headed for the crater and bankruptcy. Large funds saw this and multiple companies began shorting the stock.

Shorting Stock

Shorting is the process of borrowing shares in a company at a price that the borrower thinks will go down and promises to give the shares back after a certain time. The shorter then sells the stock for the presumed higher price and buys it back later for a lower price, gives the loaned shares back, then profits the difference. The shorter is betting against the company’s stock, hoping for them to fail. This works great, unless the stock price goes up. Then, the shorter has to buy back shares at a higher price, incurring a loss, sometimes huge. Sometimes they will even buy more shares at the higher price to pay back but keep their short position in the hopes that the price will crash.

What actually happened?

Some denizens of Reddit saw this was happening and realized that these companies had borrowed more shares than actually existed. They also noted that a few important signs of life had shown up in GameStop, a deal with Microsoft, and the impending release of new gaming consoles, which might buoy GameStop’s profits. They theorized that if enough Redditors would buy up GME shares and hold them, they would drive the price up, but more importantly, there would be no shares for the hedge funds to purchase in order to repay their debt. They would be forced to take cash loans to make huge offers in order to entice people to sell.

While the plan started in August it took until last Monday for enough investors to buy in to see a movement in the market. When GME’s price started hockey-sticking up, more joined the bandwagon, and GME shot up to unfathomable prices. Hedge funds like Melvin Capitol lost billions of dollars, while Redditors laughed, and the rest of the world wondered what happened.

The meteoric rise and tremendous volume of shares traded triggered some emergency stops and some brokers such as Robinhood restricted sales. Later, Legislators weighed in and there will surely be lawsuits and bills dropped in congress to increase regulations. But it’s not over yet.

This weekend, everyone is wondering what will happen when markets open Monday. There is a huge churn in GME and other stocks experiencing similar stock squeezes. Those who got in early stand to make a huge profit, but if enough of them sell, the stock will undoubtedly crash, and the hedge funds that managed to hold out will win. On the other hand, if enough hold on, the share price will continue to drive upward, hedge funds will blink and have to buy, and, well, it’s difficult to know who wins. At some point those holding shares at huge prices will have to sell in order to realize their profit. That’s the time that the stock goes down and whoever is left with shares feels like they lost money.

Should I buy GME?

You should have, looking back. But that’s silly because back when it was trading at $5.00 you probably wouldn’t have. GameStop is still in a terrible position, with games more and more coming to the home via the internet instead of purchased at stores. Nearly every sign pointed to decreases in the stock.

Okay, should I buy GME Now?

It all depends on whether you think it will continue to rise. I think that GME went up on the basis of those on Reddit who were able to convince others. Toward the end of the week, the stock plateaued on average (with large swings). That tells me that the pool of buyers has already been tapped and now are churning. It will take more outsiders to think that there is more room upward and buy in for the price to go higher. I don’t think they exist.

We know that trying to time the market is worse than just buying and holding over the long run. I stayed away from GME and not just because I’m long on real estate. I think it’s a gamble; if you have money you can lose, then do your research and get in when you think it is best. I think the rocket has left the station on this one.

Dr. Equity