Investing is Not a Game. Stop.

Did you catch snippets of information about the GameStop trading debacle?

If not, I am glad you are otherwise occupied with  meaningful activities.

Following “day traders” who try to take down Wall Street Hedge funds by running up the stock price of Game Stop has been another lesson learned for individual investors. 

GameStop was on the verge of bankruptcy. So why would it suddenly be worth $480?

The quick rise and fall of a very flawed investment strategy has brought the stock price down to $40. Leaving a lot of “believers” in social media investing holding the bag. 

Is the Robinhood/Reddit/GameStop culture a gang of thieves ? Taking from the rich and giving to….?

Who are these guys anyway?

Robinhood: 

Robinhood is a stock trading application that offers free  stock trades. 

I find the name ironic. Wasn’t Robin Hood and his band of Merry Men (except for one woman, Maid Marian) the guy who stole from the rich to give to the poor?

The purpose of developing the Robinhood app is for Robinhood LLC to become a publicly traded company through an IPO ( Initial public offering).

If the IPO is successful, the creators of the app become wealthy overnight.

Hedge funds, who provided capital to Robinhood , are reimbursed, and stand to make a whole lot of money. That is why they invest in startups.

So how exactly do the poor benefit?

The mission statement of Robinhood talks about the democratization of stock trading for Main Street investors.

I guess they had to think of something to say to attract younger investors, especially with a catchy name like Robinhood. 

What they don’t say is that the whole idea of providing financial services, like stock trading to individual investors, is to make money. A lot of money.

Reddit/rWallStreetBets:

Reddit is a  social media platform. Wall Street Bets is a subreddit group that likes to speculate on very risky stocks. 

Members of Reddit/WSB glommed on to the idea that  Main Street investors should  buy GameStop stock.

Why ?

To drive up the price of the stock. Never mind the stock was close to worthless and the company on the verge of bankruptcy. 

Driving up the price of the stock would cause serious losses to Wall Street Hedge Funds who sold the stock short.

Although the stated purpose of the ‘short squeeze” ( I am going to explain what this is ) was to take down Wall Street Hedge Funds, that didn’t happen.

In fact, the strategy made a lot of people a lot of money , including Reddit followers who got in early and sold as the stock price went “to the moon.”

Hedge Funds: 

There are 2 things you need to know about hedge funds.

Number One:

The objective of a hedge fund is to provide superior returns to investors. Hedge funds do this by using strategies unconstrained by conventional investment guidelines.

Hedge funds are intrinsically “risky”.

Number Two:

Because hedge funds are considered “risky” , hedge funds are only open to “qualified investors”. That means people who can invest a lot of money and lose a lot of money without it making a dent in their wealth.

“What, I’m down $2 million ? C’est la vie ! More champagne anyone?” 

The Reddit followers decided to engage in a strategy called a “short squeeze”.

Short selling  is a strategy. It is implemented by hedge funds and institutional investors who believe a stock price is going to go down. 

It sounds counterintuitive to make money when a stock price goes down so I will explain the basic concept:

You own a dress that I would like to borrow and wear to an upcoming event. You paid $300 for the dress. I cannot afford $300 today but I believe the dress is going to go on sale, only not in time for my event. I think the price of the dress will go down to $100.

I borrow the dress and promise to return it unscathed by cheap red wine or Cheetos.

The event takes place and “oh no”  the dress meets the  bottle of cheap red wine and they are both ruined by morning.

I now must replace the dress and it is going to cost me $300.

But look! Sales have started and I was right, the price is down to $100. At that price I can buy the dress and replace it for $100, theoretically(making) saving $200. I’m thrilled.

But wait, here come the mean girls. And I mean, mean. They know of my predicament and  buy the dress before I can.

They will sell me the dress for $400, knowing my time is running out to return the dress. I pay $400.

In Wall Street parlance this is called a “short squeeze”. Squeezing has nothing to do with getting in the dress, but the visual is the same.

I didn’t own the dress, I borrowed it ( I was short). When I needed to return the dress, it cost me $400 to replace it . This is called the “squeeze”. Even though I was correct about the price of the dress going down, someone else nabbed it and drove the price up, forcing me to pay $400 instead of $100.

The GameStop story didn’t stop at the short squeeze though. The gang from Reddit managed to convince other retail investors that the price of the stock would continue to “rocket to the moon”. More and more buyers came in and continued to drive the stock price up. 

A couple of the hedge funds are now out of the trade, squeezed out. They took their losses and moved on.

The Reddit guys who bought the stock at a low price are starting to sell, making some nice profits. 

Today the stock price of GameStop is around $40 a share, after soaring to $480. If you paid anything above $40 per share, you are looking at losses.

The stock won’t soar because no one wants to buy it. This was all just a game. 

Here is the real irony now that you understand short selling. Hedge funds took losses that is true, but hedge funds always take gains and losses. 

GameStop wasn’t the only game in town for the hedge funds.

As the price started to soar, other hedge funds and institutional investors thought, “this price is never going to hold” and THEY started selling the stock short, laughing all the way to the bank as they say, as the price went from $480 to $40.

Not only did the Reddit traders not take down any hedge funds or Wall Street, they managed to make a lot of very rich people richer.

And what happened to the individual investors who got wiped out?

C’est la vie.

In come the regulators and the hearings.

Was there stock price manipulation? Was Robinhood allowed to halt trading in GameStop? Were unsuspecting individual investors taken advantage of? Were there unscrupulous traders posing as newbie investors on social media?

The story continues to unfold.

My theory is that nothing dramatic will come of this. 

Maybe Robinhood can be held accountable for violating the “Know Your Client” (KYC) rule?

Did they entice unqualified investors to use options and borrow on margin? 

Did they make it too easy for someone to click a box that says “ Yes, I have extensive investment experience”  without a thorough vetting?

It is hard to vet anyone if you have no customer service people looking customers in the eye.

Did the Reddit gang manipulate the stock price? 

All information about the financial condition of GameStop was public. It wouldn’t take much for an investor to find out what the stock was worth. 

Not what the Reddit players said it was worth.

Do we need more regulation to prevent people from gambling in the markets?

Did innocent bystanders get hurt?  Naw, maybe they lost money but Sorry, the stock market is not a casino. 

Investing is Not a Game. Stop.

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.