This is widely presumed to be the first time in history that ordinary people have caused such tremendous losses for a multibillion dollar hedge fund. Sometimes understanding what exactly is happening on the stock market can be difficult, especially for those who are not too familiar with all the terms it can be a real challenge.
To understand what has actually happened here, it is important to have some basic knowledge on how the stock market works and what shorts are.
If you see a company on the stock market that you think will decrease in value, you have the option to sell a so called short. To get a short, you borrow a stock from a broker and proceed to sell it immediately, then you wait until the price has dropped enough and buy back that share. Now you can give it back to the broker you got it from and keep the difference.
To make this easier to understand, imagine you borrowed one share from a company that is currently valued at €100, you now sell that share for €100 to someone else. Now let’s say that over time the value of that share has dropped to €60, you can now buy back one share for €60 and return it to the broker. The difference is your profit, in this case €40.
What can also happen though, is that instead of decreasing in value, the stock you borrowed increased in value. Now you have to buy the stock back at higher price, let’s say €130, in order to return it to the broker. In this you have now lost €30 on this trade.
This is more or less what happened with the GameStop stocks. GameStop is a gaming merchandise retailer that sells consoles, games and electronic equipment but the pandemic has hit this business hard and the value of the company started to decrease.
The hedge fund “Melvin Capital”, valued at 13 billion dollars, saw this as an opportunity to take a massive amount of short trades and bet against the company. This would have probably worked quite well and would have brought in a lot of money too, if it wasn’t for one very alert Reddit user, who picked up on Melvin Capital’s move and convinced the whole community on the forum r/wallstreetbets to join forces and start investing in GameStop.
Soon thousands of people bought as many GameStop stocks as possible, driving the price to unexpected heights and causing Melvin Capital to lose billions. With the prices continuing to rise, the hedge fund had no other option but to buy back the shorts at a much higher price, sending the prices of the stock even higher. This is called a ‘short-squeeze’.
This has caused huge problems for hedge funds and left others fearing the same would happen to them.
In an attempt to protect companies like Melvin Capital, several brokerages limited, or completely blocked trading for GameStop stock, while hedge funds were still allowed to trade, which in turn caused an uproar from ordinary investors and even lawmakers spoke out against brokerages like Robinhood, who by now lifted the restrictions imposed on those stocks.