When an unknown stock out of nowhere makes all the major headlines and takes over FinTwit, you will do well to pay attention to the story of what may be going on.
GameStop qualified for that description this week. Ordinarily, I don’t do so much as follow individual companies except they are interesting to me. So when GameStop started appearing here and there on my timeline, my default mode was to switch off my attention signal to it. But it persisted and I could not help but catch-up on the story. It’s a wild one and the most important lesson for me is that we can’t predict the future and the best we can do is to keep an optimistic view of it because humans will always find a way to progress.
So what’s the story?
A group of people on Reddit under the subreddit r/WallStreetBets (2.6 million members) saw that a stock has been shorted way too much. In fact, it would conveniently make the list of one of the most shorted stocks in history. Seeing that, they decided to organize one of the most popular if not the most popular games in the market. They started buying the stock. The result of buying the stock is that demand on the stock starts to rise. And as we learned from basic economics, when demand for a particular product/service starts to rise beyond the available supply, the price would naturally go up. That’s basic economics.
Shorting stocks means borrowing a stock today and selling it with the expectation that the price will fall further in the future. If it happens that things go as planned and the price falls further, the investor who borrowed earlier will simply buy the stock back at a lower price and return the borrowed shares. On the other hand, if instead of the price going up, the price starts going down, the investor who had earlier borrowed the stock will have to buy back the stock at a higher price in order to limit their loss.
That is, you borrowed it at $10/share and now the price is rising instead of falling, let’s say it’s now at $15/share. The investor quickly buys the shares at 15 so he can return to limit their liability. This process of quickly buying back to forestall liability is called short squeezing. The problem with this process though is that the more the investors demand the stock, the higher the price of the stock would go. They end up in a trap and the liability can be unlimited.
So as Redditors started buying GameStop, this happened and the hedge fund investors started losing money on an unprecedented level.
What are the lessons?
No doubt, the coordinated effort is now successful. Let’s talk about ramifications.
Like I mentioned earlier, the most important lesson for me is that the future is unpredictable. If you think you could have seen what’s happening to GameStop coming and you could have benefited from it, you are still far away from understanding the workings of the world. Sure, if you were a member of the community that masterminded this, you would have gotten information and maybe benefited. Alas, you are probably not. The benefit of hindsight can be misleading many times.
If the future is unpredictable, what can we all do then? Betting on a future of prosperity is the most reasonable thing to do. Yes, you just need to be guided on how you place your bet. The world rose from abject poverty to abundance that it is today based on human ingenuity, I am not ready to write off that ingenuity today. It is such ingenuity that caused the hedge funds to lose billions of dollars today, albeit a market manipulation scheme. It is easier to win if you bet on prosperity than betting on failure.
How to bet on prosperity is to identify a company at the edge of innovation and scientific breakthrough and put your stake with them or otherwise, bet on the sum total of all human effort represented by the total stock market index. If these hedge funds had not tried to predict the future and bet on woe, this wouldn’t have happened. The butterfly flapping its wing did not set a good condition in this case for some. We could argue it did for those who masterminded the scenario.
Some other lessons:
- Don’t ever short a stock
The future is unknown and optimism is more rewarding. Neutral is better than shorting, even if you are convinced of an impending end. If you think you are very convinced that the stock will go one way, ask the hedge fund guys where their conviction brought them. If you think it cannot happen to you, you have not read enough articles on this blog, “risk always looks impossible until it happens” is an intrusive statement.
Believe rather in prosperity and invest accordingly.
- Retail Investors have become more power
Throughout last year, comments were flying here and there about how Robinhood traders who don’t understand the market are pumping share price up. Some professional investors would probably have wished such access wasn’t made available. Unfortunately, it is available and can’t be taken away again. And the retail traders have demonstrated in the past 14 months that they have enormous power over the market just as much as the big guys could have. Always put that into consideration going forward.
- This is not the end, legal possibilities
Market manipulations are illegal in the market, and this is a whole new dimension to it. So expect the men of the law to step in at a point in time. We will have some new guidance.
Did you wish you had participated on the GameStop ride at least to benefit a little? In this other article, I explained a methodical approach you can take to doing that.