A pedestrian wearing a protective mask walks past a GameStop store in the Herald Square area of New York City on November 27, 2020. | Gabriela Bhaskar/Bloomberg/Getty Images

How a bunch of Redditors made GameStop’s stock soar, much to the chagrin of the hedge funds attempting to short it.

Who knew the first big 2021 stock market story would be … GameStop? But here we are.

Day trading and individual investing have boomed over the past several months, with activity often taking place or being discussed on platforms such as Reddit and Robinhood instead of in more traditional arenas. And one big question amid the frenzy has been how much the little guys really matter. Sure, small-time investors trade a lot, sometimes to the annoyance of more traditional institutions, but are they really consequential?

In the GameStop saga, at least, the answer is yes. An army of traders on the Reddit forum r/WallStreetBets helped drive a meteoric rise in GameStop’s stock price in recent days, forcing halts in trading and causing a major headache for the short sellers betting against it and banking on the stock falling. It’s a captivating David vs. Goliath story, where David — at least on some fronts — appears to be winning.

Famed investor and CNBC personality Jim Cramer called the GameStop drama the “squeeze of a lifetime.” Bloomberg opinion columnist Matt Levine posited that one possible explanation for what happened could be “utter nihilism” on the part of the Reddit crowd, a story “perhaps best told with a series of rocket emojis.” Or maybe one of the WallStreetBets moderators put it best to Wired: “It was a meme stock that really blew up.”

There has been a lot of hand-wringing about the day-trading trend and this new crop of investors playing the markets, many of whom are treating stocks more like a spin at the roulette wheel than a long-term strategy to build wealth. It’s not clear how many of them are looking at the underlying fundamentals of companies, or whether they’re just “YOLO-ing” themselves across the market.

On GameStop, the answer is probably a mix. There’s a reasonable business case to make for (some of) the game retailer’s valuation; there’s also a case that this whole thing has just been quite fun for everyone — the possible trolls of Reddit, market watchers, commentators, and certainly GameStop — except for the short sellers, who have been in for a pretty miserable ride.

“It’s dramatic, and you don’t see this magnitude very often,” said Nick Colas, the co-founder of DataTrek Research. “But when it happens, it’s spectacular.”

More traditional investors (and those with a lot of money) have wagged fingers. But giant banks and hedge funds aren’t exactly a bastion of responsibility — take a look at the role they played in the 2008 financial crisis.

The animosity flows both ways. In a January 25 post titled “An open letter to CNBC,” one WallStreetBets Redditor pointed out that much of the network’s audience is composed of the retail traders who are now being criticized. “Your contempt for the retail investor (your audience) is palpable and if you don’t get it together, you’ll lose an entire new generation of investors,” the Reddit user, RADIO02118, wrote.

The user pointed out that the hedge funds that take on big risks can get a bailout — as one of the ones shorting GameStop did — whereas everyday investors generally can’t: “We don’t have billionaires to bail us out when we mess up our portfolio risk and a position goes against us. We can’t go on TV and make attempts to manipulate millions to take our side of the trade. If we mess up as bad as they did, we’re wiped out.”

And it’s far from certain GameStop’s stock price will stay high forever. On Thursday, January 28, its price began to fall, and trading platforms such as Robinhood began to clamp down on the trading frenzy around this and other volatile stocks — a move that sparked fury among some traders. That evening, Robinhood announced it would reinstate limited trading on those stocks the next morning.

An attempt to explain what is going on here, for people who don’t follow markets at all

Let’s back up a bit to go over the basics of what is going on here.

GameStop is a video game retailer headquartered in Grapevine, Texas, that operates more than 5,000 stores. Between malls dying out and the pandemic, if you forgot the company existed, that would be fair. But it’s still out there, trucking along. GameStop has become a popular play among short sellers, who are basically investors who think a stock will go down. In Wall Street terminology, these investors are bearish on a stock’s prospects. Again, dying malls plus pandemic. You get the reasoning. (Plus, GameStop has had a rocky history and faces a long-term threat from digital game downloads.)

Though the buying frenzy around GameStop hit in January, this one has been in the making for a while. Brandon Kochkodin at Bloomberg recently laid out how GameStop, which isn’t expected to even turn a profit until 2023, has seen its market skyrocket, and what Reddit has to do with it.

By Kochkodin’s recounting, a bull case for GameStop (basically, an argument that its stock is good) started showing up on WallStreetBets about two years ago and has, off and on, been bubbling up. Scion Asset Management, the hedge fund run by Michael Burry, who you might know from The Big Short, revealed he had a position in the company, which inspired some confidence, and then Ryan Cohen, the co-founder of the pet e-commerce company Chewy, disclosed last August that he had a big stake in GameStop. Earlier this month, he was added to its board. That’s been interpreted as positive for GameStop.

As Reddit and retail traders started to take notice of GameStop, they also took notice of how heavily shorted the stock was — information that’s generally pretty easy to get. And they figured out a way that, if they acted all together, they could sort of screw the shorts over and make a profit doing it. Kochkodin points to a post from four months ago as an instigator. Its subject: “Bankrupting Institutional Investors for Dummies, ft Gamestop.”

How a short squeeze is making Reddit happy and short sellers sad

GameStop’s stock price has skyrocketed from where it was at the start of the year, at under $20, to nearly $350 at market close on January 27. The stock slid to under $200 at market close on January 28, the day Robinhood clamped down on buying it, and after that was lifted, the stock shot up again. The stock’s volatility is the result in no small part of Redditors and the short sellers they went after. WallStreetBets has an antagonistic relationship with shorts — many retail traders are betting stocks will go up, not down.

Lots of hedge funds and investors are shorting GameStop, but at the center of the current saga is Citron Research, which is run by famed short seller Andrew Left. Last week, Citron announced on Twitter that it would be hosting a livestream event laying out the short case against GameStop and arguing people buying the stock were “suckers at this poker game.” They predicted shares would go back to $20. The event was put off, first because of the presidential inauguration, then because of attempts to hack Citron’s Twitter. Eventually, they got the video out, and the battle has continued. Left said he’ll no longer comment on GameStop because of the “angry mob” that’s formed against him and complained he’d “never seen such an exchange of ideas of people so angry about someone joining the other side of the trade.”

Retail traders have been able to orchestrate what’s known as a short squeeze against Citron and the others betting against GameStop, which screws up the short trade and drives the stock price up. (Don’t worry, we’ll explain what that is.)

When a hedge fund or investor shorts a stock, they basically speculate that its price will go down. They do that by borrowing, usually from a broker-dealer, shares of a stock that they think will lose value by a set date and then selling them at the market price. “It’s a much more sophisticated investor kind of play,” Colas said. “[The bet] has to work pretty quickly, because what you don’t want is your short stock at $10 and it goes up to $100, because you can lose more than 100 percent of the capital that you put down.”

When you short a stock, you have to at some point buy back the shares you borrowed and return them. If the trade works, you buy them at a lower price and get to keep the difference. But if the price of the stock goes up, it doesn’t work. At some point, you’ve got to buy the stock back and return it, even when the price is higher and you’re going to lose money.

What happens with a short squeeze is that when the price of the stock being shorted starts to climb, it forces traders betting it will fall to buy it, to try to stem their losses. That drives up the price of the stock even higher, so it’s a bit of a double whammy for shorts. The worst-case scenario is, theoretically, unlimited.

“The short squeeze is when somebody says, ‘Oh, I know a lot of guys are short. I’m going to go long and make them buy the stock back even higher,’” Colas said.

To add another layer to this, a lot of the activity around GameStop hasn’t been people directly buying the stock, but also buying call options, where they basically gamble that it will go up. It’s complicated, but the takeaway is that call option buys may have also driven up the stock because the market maker selling those options hedges by buying more stock. And there was a lot of options buying, namely among day traders — volumes have skyrocketed, and one WallStreetBets trader claimed to have turned $50,000 into $11 million playing options.

Levine summed up what amounts to a snowball effect:

Something started the ball rolling—the stock went up for some fundamental or emotional or whatever reason—and then the stock going up forced short sellers and options market makers to buy stock, which caused it to go up more, which caused them to buy more, etc.

The shorts are definitely hurting: Melvin Capital Management, a hedge fund betting against GameStop, was down 15 percent in just the first three weeks of 2021, according to the Wall Street Journal. It’s had to call in some help and finally closed out its position altogether. Left, the Citron short-seller, announced his shop would stop publishing “short reports,” ending a practice it’s undertaken for 20 years.

Meanwhile, many big names are following along. On Tuesday, January 26, Chamath Palihapitiya, a venture capitalist and the founder of VC firm Social Capital, tweeted that he was buying GameStop calls. And Tesla’s Elon Musk, whose tweets often move stocks, tweeted, “Gamestonk!!” with a link to r/WallStreetBets.

The White House said it was monitoring the GameStop situation, and the Federal Reserve and Sen. Elizabeth Warren weighed in as well. On January 27, the Securities and Exchange Commission said it was “monitoring market volatility.” Two days later, it put out a lengthier statement warning that “extreme stock price volatility has the potential to expose investors to rapid and severe losses and undermine market confidence.” It also said it would “protect retail investors when the facts demonstrate abusive or manipulative trading.”

“They’re smarter than we think”

The GameStop episode is a mix of factors serious and silly — part retail traders demonstrating some actual power in the market, part accepting that some of this just makes no sense. Whether GameStop took off because it’s a meme stock — a stock in which interest is as much cultural or social as it is financial — or because there is something to the business case is unclear. There is a business case, there is a cultural interest; the balance between the two in driving the price is indeterminate. Part of it might basically be a joke. What is clear is that a lot of what’s happening with the stock now isn’t because of a potential turnaround; it’s because the trade went viral.

“It doesn’t make business sense,” Doug Clinton, co-founder of Loup Ventures, told Bloomberg. “It makes sense from an investor psychology standpoint. I think there’s a tendency where there is heavy retail interest for those types of traders to think about stocks differently than institutional investors in terms of what they’re willing to pay.”

Day traders are hardly a monolith, including the ones at WallStreetBets, which boasts nearly 3 million members, or as they refer to themselves, “degenerates.”

But though this is a bit of an odd (and somewhat inexplicable) episode, it still involves some bigger issues.

For one thing, it seems like the WallStreetBets crowd has learned a tactic that it can replicate in orchestrating short squeezes. “What they’ve done is target large short positions,” Cramer said on CNBC on January 25. “They’re smarter than we think. They’re after the ones that are too shorted.”

Following the GameStop episode, retail traders have also piled into stocks such as AMC, BlackBerry, Express, and even Tootsie Roll. Robinhood and other trading platforms have begun to restrict trading on certain volatile stocks, including GameStop and AMC. That has prompted blowback from retail traders and some high-profile figures, such as Barstool Sports’s Dave Portnoy, who say platforms are unfairly barring them from opportunities and siding with hedge funds and institutions.

The reasoning for clamping down on trading is unclear; Robinhood’s stated mission, after all, is to democratize finance. The company could be trying to protect traders from taking on too much risk (though the accessibility of its platform arguably pushed those traders toward risk in the first place). Or there may be concern about potential legal repercussions from users if stocks go south. There’s also been some speculation about Robinhood’s relationship with a major investment fund being a factor.

Robinhood raised $1 billion from investors overnight on Thursday, January 28, and drew on bank credit lines to shore up its operations and make sure it has enough money to let people keep trading. Robinhood CEO Vlad Tenev also appeared on CNBC to address the matter. “We just haven’t see this level of concentrated interest market wide in a small number of names before,” he said. In other words, individual investors haven’t worked together to impact specific stocks like this before, at least not to this magnitude and with this level of technology.

Robinhood did not respond to a request for comment.

Some observers have raised questions about whether what’s happened with WallStreetBets and GameStop might draw regulatory scrutiny around possible market manipulation. Colas said he’s doubtful there’s much of a case for that. “Everything is known. There’s no insider information here,” he said. If a hedge fund shorting a stock can put out a presentation and video about why a company is bad, why can’t random people talking to each other on the internet talk about why a company is good? But of course, on the legal front, reasonable minds might disagree.

One of WallStreetBets’ moderators addressed the impression that the community is “disorderly and reckless” in a post on January 24, while pushing back against any suggestions there is an organized effort among moderators to promote or recommend any stock. “What I think is happening is that you guys are making such an impact that these fat cats are worried that they have to get up and put in work to earn a living,” the moderator wrote. “Some of these guys [who] traditionally used the media as a tool for them to manipulate the market have failed to further line their pockets and now want to accuse you guys as being manipulators.”

GameStop has been the perfect storm for the current retail trend. It’s a recognizable name, there’s some business case for it, and it’s turned into a meme. And it’s heavily shorted, which is bound to irk the recent crop of retail traders who subscribe to the mantra that “stocks only go up.”

On January 26, I reached out to the moderators of WallStreetBets to see what they make of what’s happening. One moderator, Stylux, suggested there wasn’t much mystery. “We aren’t looking at anything other than what is right in front of us, which is the same thing you are seeing. It’s up to the user base to pick stocks — we only moderate a forum for them to do that,” they wrote, adding that they have made efforts over the years to enforce rules aimed at preventing schemes and barring certain investment vehicles. “Everyone plays by the same rules,” Stylux wrote. Their takeaway:

What you are seeing is conviction from some traders in the subreddit coupled with the pure greed of short sellers who had an opportunity to cover and refused to do so. It looks to me that institutional money is now moving against the short sellers.

An example of this is the breaker that occurred shortly before close which looked like a 2.3M share market sell to me. The stock plunged instantly, and when trading resumed it was right back to where it was before that sale. I would be very skeptical of anyone who tries to tell you that retail is making GME move at this point. Some users got the ball rolling and here we sit — with $GME at $209 after hours. Some of the users can now pay off their car notes, student debts, feed their kids and pay their mortgages. Who can feel bad about that?

WallStreetBets has been feeling the heat, too. The Reddit forum briefly went private on January 27, and the messaging platform Discord shut down the WallStreetBets server in its app the same day due to “hateful and discriminatory content.” The Verge reports that Discord is now working with WallStreetBets to help moderate its content.

This isn’t the first time day trading has become trendy, nor is it the first time day traders have been accused — often rightly — of being a little bit reckless. Last summer, some of them piled onto bankrupt Hertz, for which there was really no good case. Many of them treat trading like a game, which can obviously be dangerous. But it’s hard to root against them. Plenty of hedge funds, short sellers, billionaires, and institutional investors treat investing like a game, too. And every once in a while, they’re bound to lose, too, even to the little guys.