February 2021 Monthly Insight – The Reddit Short Squeeze

Posted By T. Lee Sherbakoff, CPA/PFS, CFP® on Feb 1, 2021


“When it comes to luck, you make your own.”

— Bruce Springsteen, American singer, songwriter, and musician

Perhaps over the last few weeks you’ve come across financial news containing terms you don’t completely understand.  You may have seen words and phrases like GameStop, gme, short squeeze, Reddit, hedge funds, WalStreetBets, or even “up 700% in one week.”  You may be just as confused by “up 700%” as you are over what is a Reddit.

Perhaps you also came across the confusing phrase “zombie companies.”  This refers to companies that earn just enough money to continue operating and service their debt, but are unable to pay off debt. They are typically subject to higher borrowing costs and may be just one event away from insolvency or a bailout.  These companies may also have the moniker of “deep value” stock.  A deep value stock is one of the cheapest stocks available, based on their valuation multiple.

GameStop (ticker GME) is a retailer that sells video games – not online, but in hard-copy form of DVDs. Because many of the company’s store are in large malls, this business model has become a problem (because, increasingly people buy games online and don’t shop at malls).  Gamestop’s total revenue has dropped $2.1 billion, or 24.3%, since 2018.  To many analysts, GameStop was a zombie company; they thought the stock price was too high and would have to drop.  In such dire straits, many zombie companies have falling, low, or distressed stock values.  In fact, GameStop’s 52-week low closing price was $2.57 on April 3, 2020.

It is, in fact, true that stock traders can make money in both rising and falling markets. If they believe that a certain stock will go up, they will buy the stock out right and hold it.  This is known as being “long” on a stock.  Also, a hedge fund manager with a positive sentiment about a stock could buy Call options on that stock.  Call options give the owner the right buy a stock at a specific price in a certain time frame.

Interestingly, though, some hedge fund managers may have the complete opposite sentiment about a company’s stock and feel extremely confident the company’s stock will fall in value.  In that case, the hedge fund can borrow the shares from someone who is long on the stock, then sell those same shares now and later buy the shares back after the price falls.  When a hedge fund or trader borrows shares, sells them, and is waiting for the stock to drop in price to buy back those shares, that is called being in a short position.

So, if a hedge fund, stock trader, or day-trader buys 100 shares of Apple, they are “long” Apple.  If the hedge fund, stock trader, or day-trader borrows 100 shares of Apple from a broker and sells it today and plans to buy it back later after a 15% drop, they are “short” Apple.

Reddit is a social news aggregator that hosts user-created content and is organized by subjects in “communities” or “sub-reddits.”  Reddit is in the top 20 of most visited web sites in the world and is in the top 10 in the U.S.  WallStreetBets is a subreddit where users discuss stock and option trading and has over 7.5 million users.

In January, many WallStreetBets members began to buy shares or options on GameStop, which at the time was one of the most highly shorted stocks.  This buying action caused the stock price to rise and started a short squeeze on those having shorted the stock, causing major financial consequences for certain hedge funds and large losses for short sellers.  Approximately 140 percent of GameStop shares had been sold short, and the rush to buy shares to cover those positions as the price rose caused it to rise even further.

Let’s recap that last paragraph: Ironically and yet predictably, WallStreetBets’ action caused the stock price to rise and the hedge funds’ response made the stock price climb even higher, causing the hedge funds to lose more money.  It was as if the stock price had become a perpetual motion Quantum energy generator, creating more energy than it consumed.  Or, as those in the military might relate to, the stock runup became a self-licking ice cream cone, a self-perpetuating system that has no purpose other than to sustain itself.  Regardless, with all this market movement and roller coaster action, many small dollar Reddit members brought down several Wall Street hedge funds and made a lot of money for themselves, too. 

If someone made the perfect call in timing this market action and bought 100 shares on January 4, your $1,715 investment would have grown to $34,751.  But, we doubt anyone did, in fact, make the perfect trade.  And, if they did, are they smart and a successful market timer or just lucky?