What’s Happening with GameStop?

To start off 2021, GameStop Corp. (Ticker: GME), a brick-and-mortar retail establishment focused on video games and electronics, has been the subject of a short squeeze. This is said to be started by r/WallStreetBets, an approximately 3.1 million user subreddit group, and is egged on by billionaires such as Elon Musk and Chamath Palihapitiya on Twitter.

To implement the short squeeze strategy, the group of investors are purchasing equity positions (i.e., going long)  in GME as well as buying out-of-the-money call options, which give the holder of the call the right to purchase GME stock at a set price, known as the strike or exercise price.

On April 3, 2020, shortly after the start of the pandemic, GME was trading at $2.80/share, representing the stock’s low for calendar year 2020. As of market close on January 26, 2021, GME’s price had skyrocketed to $147.98/share, representing an approximately +5,185% return since the low of 2020, and an approximately +685.46% return YTD (year-to-date). The stock continued to surge aftermarket close on January 26, and before market hours on January 27, breaching $200/share. Shortly after market open on January 27, 2020, the price of GME climbed above $300/share (Exhibit 1).

GameStop: A Brief Background

Along with other brick-and-mortar retailers, GME has struggled to stay afloat as consumers increasingly demand online and digital platforms. While this struggle was amplified by the pandemic, it was present prior to the COVID-19 situation. For example, GME posted a net loss of -$673 million in 2019 after reporting several years of declining profits (Exhibit 2).

In March of 2020, around the start of the pandemic, GME announced it would permanently close 300 locations. By years end, the number of closures was in excess of 450 locations. Following the news of the original closures, and the increasing pandemic-related restrictions and lockdowns, the stock hit an all-time low of $2.80/share on April 3, 2020.

In August 2020, things began to take a more positive turn for GME when Ryan Cohen, co-founder of online pet retailer Chewy Inc., took a 9% equity stake in the company. In November 2020, Mr. Cohen wrote a harshly worded letter to GME’s Board of Directors, criticizing GME for its errors, with a focus on the company’s inability to keep up with “the transition from physical hardware to digital streaming.” By late December 2020, Mr. Cohen had increased his equity stake in GME to approximately 13%. As investors perceived Mr. Cohen’s position as a positive for GME’s future, GME’s stock price steadily increased in the wake of the news (Exhibit 3).

Short Selling and Short Interest

SHORT SELLING

Short selling is an investing strategy in which the investor seeks to generate profit from a decline in a company’s stock price. To implement a short strategy, an investor borrows shares of the company it would like to short and sells the shares at the current market price. The short investor has the intention of purchasing the shares back on the market later, ideally at a lower price, which will then be returned to the lender of the shares (Exhibit 4). In a short strategy, the investor is betting that the company’s stock price will decrease in the future, effectively betting the performance of the company will decline over time. This allows the short investor to profit on the difference between what they sell the borrowed shares for at present (ideally at a high price), and what they buy the borrowed shares back for in the future (ideally at a low price). Recall, a fundamental concept in finance is the notion to sell high and buy low.

In September 2020, following Mr. Cohen’s increased equity stake in GME, the company’s share price began to increase. Several institutional investors believed the increase in GME’s stock price represented an overvaluation of GME’s intrinsic (or true) value. As a result, these investors took out large short positions against GME. These investors bet the company’s stock price would decline and that they would profit from GME’s decline by selling borrowed shares at a high price and then waiting to purchase back the borrowed shares until GME experienced a price dip.

SHORT INTEREST

Short interest represents the volume of a company’s shares that have been sold short but have not yet been covered or closed out. This can be thought of as the number of company shares that are still out on loan (i.e., are borrowed and have not yet been returned). As institutional investors increasingly entered short strategies, short interest in GME increased, recently sitting at approximately 71.2 million shares.

This short interest is crucial to compare to GME’s total number of shares outstanding, some of which may be restricted from trading, and float (i.e., the number of shares available for trading), which are approximately 69.75 million and 46.89 million, respectively. Using these figures, short interest as a percent of shares outstanding is approximately 102.08%, while the short interest as a percent of float (i.e., shares available for trade) is 260.91%. This indicates that there are significantly more shares in short interest (i.e., out on loan) than there are available for trade. This set the stage for the short squeeze.

The Short Squeeze

Taking a short interest position is generally considered a sophisticated strategy, primarily made by institutional investors. This is considered a sophisticated strategy because there exists the theoretical potential for infinite loss. Under the short strategy, short investors profit as the stock price on the market declines, effectively capping their profit if the stock price falls to zero – the lower bound for stock price. In contrast, the short investor loses as the stock price increases. The higher the stock price, the more the short investor loses. Because there are no upper bounds for price, in theory, the short positions loss could be infinite and significantly larger than their initial investment. To mitigate this risk exposure, as stock prices increase, short investors may begin to purchase back some of the stock to reduce potential losses. For example, if the short seller sold the shares initially for $30, she may begin to purchase back the borrowed shares if the stock price hits $40 to cap her losses at $10 per share, preventing a larger loss if the stock price continues to appreciate (i.e., increase).

A short squeeze may be initiated in companies that have a large amount of short interest, such as with GME. The squeeze occurs when the stock price appreciates, forcing short sellers to cover their short interest positions by buying shares to return to the lenders and limit their potential losses. By purchasing shares to cover their positions, these short sellers increase the demand for the stock, driving up the price. In this manner, the short sellers work against themselves, and by mitigating their losses and buying shares, further push the price of the stock up. Companies with high short interest are targeted for the short squeeze, as there are more investors who need to cover their short positions, increasing demand to purchase shares, further boosting the stock price.

Initially, a group of investors (including those from r/WallStreetBets) took long positions in GME, increasing demand for the stock and pushing the price of GME shares up. As the price increased, the investors with short interest began to purchase shares to cover their short positions and mitigate potential losses. This further increased demand for the shares, driving up the price of GME even more (Exhibit 5).

Options: Magnifying the Short Squeeze

In addition to purchasing and selling the stock of a company, investors can also purchase options contracts that are tied to the company’s stock. There are two primary types of option contracts: 1) call options, and 2) put options. In this context, call options, which are the focus of the GME trading frenzy, give the holder (or buyer) of the option the right to purchase shares of a company at a set price (i.e., the strike or exercise price), on or until a set contract expiration date. Holding a call option initiates a long strategy, in which the investor effectively bets that the company’s stock price will increase in the future. Put options, in contrast, give the holder (or buyer) of the option the right to sell shares of a company at a set price, on or until a set contract expiration date. Holding a put option initiates a short strategy, in which the investor effectively bets that the company’s stock price will decrease in the future. Options contracts can also be used to hedge (or reduce risk) of existing equity positions to help mitigate potential losses.

Call options become profitable when the strike or exercise price laid out in the contract is lower than the current price of the company’s stock in the stock market. In this case, the holder of the call option would exercise (or use) their option, purchasing shares of the stock at the strike price, which can then be sold on the stock market at the higher market price. When the call option strike or exercise price is higher than the current stock price, this contract is said to be “out-of-the-money,” as exercising the option would not be profitable (i.e., the investor would buy the stock at the strike price for a higher price than it could sell it for on the market, breaking the fundamental guideline of buying low and selling high). However, out-of-the-money options are typically inexpensive and can have high payoffs if the stock’s market price exhibits high volatility, with the market price eventually moving above the call option strike price. In this case, the option would become “in-the-money,” and would be profitable for an investor to use.

For GME, investors, such as those in the subreddit group, purchased inexpensive out-of-the-money call options, with strike prices significantly higher than the market price of GME stock. As these investors purchased the call options, someone else had to take the opposing side of the options contract (i.e., sell the option contract which comes with an obligation to sell underlying shares of GME to the holder/buyer of the option in the event the option is used). Typically, the entity taking the opposing side is a market maker. Market makers will generally hedge these call option positions, reducing some of the risk of their positions by purchasing some shares of the company on the stock market at the current price to mitigate losses in the event the stock price increases and the call options are used.  

As market makers hedge their positions by purchasing shares of GME on the stock market, this increases demand for GME shares, and drives the stock price upwards. Additionally, as GME call options are used (i.e., holders exercise the option to purchase stock from the seller of the contract), the seller of the option may have to purchase additional shares of GME on the market. This would occur in the event the seller of the contract does not have enough GME holdings on hand to cover the number of obligated shares in the option contract. As such, the settlement of options contracts may also drive an increase of demand for GME on the stock market, further pushing up GME’s price per share. As the GME price increases, more GME call options may become “in-the-money”, perpetuating the cycle, driving prices even higher.

GME OPTION TRADING VOLUME

Over the last few weeks, GME options trading volume has skyrocketed. For example, on January 22, 2021, daily trading volume for GME reached 1.8 million options contracts, which represented approximately 180.6 million shares of GME stock (1 GME options contract = 100 shares of GME). In the prior month, GME’s average daily trading volume represented approximately 0.29 million options contracts, or 29.9 million shares of GME, indicating a 6x increase in options trading volume in the last month.

On January 22, 2021, the most purchased contract was a $60 strike/exercise price for GME stock, which at the time was “out-of-the-money.” On January 26, 2021, billionaire and CEO of Social Capital, Chamath Palihapitiya, took to twitter indicating he had purchased call options with a strike price of $115 for GME with a February expiration. GME’s stock price closed at $147.98/share. Aftermarket, billionaire and Tesla CEO, Elon Musk, tweeted about GME, helping push its price even higher in overnight trading, crossing $200/share (Exhibit 6).

Conclusion

While there are some big names egging the GME play onwards, there are others warning of the danger and insanity. On January 26, 2021, Michael Burry – famous for his mortgage trade featured in “The Big Short” – tweeted “If I put $GME on your radar, and you did well, I’m genuinely happy for you… However, what is going on now – there should be legal and regulatory repercussions. This is unnatural, insane, and dangerous.” Mr. Burry noted that he previously held a long position in GME, however as of now he’s “neither long nor short” GME.

Is the GME play over? Based on today’s market price, it seems far from it. Though it has been reported that large GME short positions, such as Melvin Capital’s, have been closed with substantial losses, the GME price appreciation is still running strong. Financial news outlets report that institutional investors may be underestimating the power of retail investors (such as the reddit users), suggesting similar short squeeze plays are possible on other high short interest companies. In fact, BlackBerry, AMC, Express, and Tootsie Roll – all companies with high short interest – have seen increased trading volume from retail investors in the past few days, causing speculation that these stocks could follow the GME short squeeze pattern.

These strategies (both shorting and the retail investors short squeeze) are incredibly risky and should not be taken on lightly. While there are individuals making significant gains from the GME play (for example, one reddit user reports turning a six-figure investment into approximately $14 million as of January 25, 2021), the risk to lose it all – and then some – is ever present (remember the short sellers from Exhibit 5 who lost $1.6 billion in one day?).This is an incredibly dangerous play and there is still some question of legality. Some question whether the r/WallStreetBets group conducted market manipulation – a charge made by U.S. Securities Exchange Commission (SEC) if investors knowingly spread false information to trick other investors into buying or selling a stock. Currently, this sits in a gray area and could be a test of Gary Gensler, President Biden’s pick to lead the SEC. Regardless, GME’s price run highlights the increased role of retail investors and online platforms/social media in financial markets.

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Dr. Kelsey Syvrud just joined the Fire Capital Management team as the Director of Investment Strategy. She is also an assistant lecturer in the Department of Finance at Florida State University’s College of Business. At both the undergraduate and graduate level, she teaches multinational finance, corporate finance and financial data analytics. She also assists in the Perspective in Free Enterprise course as the assistant director of the BB&T Center for Free Enterprise. Dr. Syvrud was previously a visiting professor at the University of South Florida. She also worked for Cornerstone Research, an economic consulting firm specializing in expert witness reports for corporate litigation, in both Washington D.C. and Los Angeles, California. She received a bachelor’s degree in finance, a master’s degree in finance, and Ph.D. with a major in finance – all from Florida State University.

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