In today's Finshots, we talk about the frenzy surrounding GameStop and explain how a bunch of retail investors on Reddit are beating Wall Street.

The Story

There are two groups fighting a war. On the one side, there is the coterie of professional investors aka the big boys on Wall Street — The ones that financial news channels love to talk about. On the other side, there is an army of risk savvy traders who congregate on the discussion forum — Reddit. They like to live life dangerously — YOLO!!!

Or as they put it —/r/wallstreetbets (the subreddit where they discuss their trades) is a community for making money and being amused while doing it. Or, realistically, a place to come and upvote memes when your portfolio is down. And for a while now, nobody has paid a lot of attention to these guys. At least, not until recently when they started betting against the big boys.

And winning while at it.

So the question is — What are they fighting over and how come these guys are coming out on top?

Well, there’s a popular company called GameStop that sells video games. Unfortunately, they built their fortune on the back of physical stores. But this isn’t the 2000’s any more. People don’t buy physical copies from video game stores like they used to. Instead, they simply download games off the internet. So, many people believe GameStop is doomed to fail.

But then — A ray of hope. Ryan Cohen, the former CEO of online pet-food company Chewy Inc started getting vocal about GameStop. Ryan, for the uninitiated, is a successful entrepreneur and someone who believes GameStop could thrive as an online e-commerce platform. He also owns 12% of the company and was recently inducted into the board in a bid to help GameStop grow and succeed.

So right now you have a bunch of sceptics thinking GameStop is as good as dead and then, you have an army of retail investors on Reddit thinking Ryan will change the fortunes of the company forever. These people want to push the stock to new highs each day and they are doing a stellar job. GameStop has been rallying like there’s no tomorrow. The stock is currently trading at about $75 a pop. Or at least it was trading at this level when I went to bed last night. But then I had to wake up when I found out the stock went up to $140 at 2 am. That’s a ~100% increase in a matter of a few hours and it doesn't seem as if it's stopping anytime soon. So how are a bunch of retail investors managing to push the stock to such stratospheric levels?

Well to understand this bit, we’ll have to discuss shorting and something called a short squeeze. Here’s one explanation from our story on Tesla —

The theoretical mechanics of short selling is rather simple. You borrow a certain number of shares of a company from your friendly neighbourhood broker and you sell these shares at the current market price — say Rs.100. At some point in the future when the stock price dips (to Rs.80), you buy the company shares from the open market at this lower price and return it to the broker. In effect, you make a profit of Rs. 20 from the transaction. It’s a nice way to bet against a company and make some money in the process.

However, if the stock price were to rally, you’d be in a bit of trouble. For instance, if the price breaches Rs. 120, you’ll have to buy the stock at the higher price and return it to the stockbroker. In which case, you’ll be walking away with a loss of Rs. 20. So there's a fair amount of risk involved. And it becomes even riskier when you consider the fact that your broker might ask you to return the shares when he or she feels like it. Or maybe they’ll ask you to pay an extra fee. But most times, you’ll simply throw in the towel yourself. You’ll probably buy the stock from the open market and return it to the broker after it breaches a certain level, maybe Rs. 150.

But there is a problem. See, you’ve already borrowed the share. You’ve sold it to somebody and now you want to return the share to the owners. But what if nobody’s selling at this point? Or let’s suppose you don’t find as many sellers?

The original thesis from the Reddit army was this — Big institutions flush with cash had borrowed large amounts of GameStop stock in the hope that its price would tank to zero. They were betting on its failure and shorting the stock in a massive way. And according to some sources, they had borrowed more shares than what was actually “floating around”.

And that means, if they were ever asked to return the borrowed shares, they would have to scramble. They would have to start paying top dollar if they wanted to incentivize the few sellers on the scene. And in a paradoxical manner, they’d be the one driving the price higher. This is called a short squeeze. And the folks over at Reddit started squeezing the life out of these institutions by going on a buying spree like no other.

But they weren’t just buying the stock. They were also buying something else — call options. Now we don’t want to complicate matters here. But a call option is a contract that will allow you to pay a small fee and make large amounts of money if the stock price rallies. A 1% increase in the stock price could be amplified 10 times when you are dabbling with this thing. However, as in any contract, there are two parties involved. If you are buying a call option, somebody is selling you a call option. And if you win, they’ll have to pay you this large sum. So they’ll want to protect their downside.

And they do this by hedging their bets. They’ll start buying the actual stock the moment they sign off on the contract. The point here is simple. If the stock price does rally and they have to pay you the money, then holding a stock (who’s value keeps rising each day) will help them offset some of their losses. I am grossly oversimplifying this bit, but know this much — When the folks at Reddit started buying GameStop call options, people that were selling these options were forced to buy the actual stock in a bid to limit their downside. In turn, these guys were also driving the prices higher.

And the stock rallied. And it rallied some more.  The “so-called retail investors”, as they are often referred to by those who disdain their type are beating the professionals at their own game. Which has prompted some people to weigh in on the matter and call out this “madness” — so to speak.

But here’s the thing. When the professionals buy bits and pieces of a loss-making company and push its valuation to billions of dollars, nobody bats an eyelid. When the VCs (Venture Capitalists) invest in startups and tell everyone they see a revolutionary new business model, people hail them as visionaries. However, when the small guys on Reddit start making a bet on a gaming retailer, everybody loses their minds. This argument is a bit hypocritical, to say the least.

Does it mean, GameStop is destined to succeed?

Maybe not!

But valuation has always been subject to the interpretation of the masses. And right now, it seems the masses think GameStop can actually script a turnaround.

Will they actually do it?

We will just have to wait and see. Until then…

Also, if you know anyone who's been talking about this story or someone who's had trouble following this crazy rally, don't forget to share this article with them on WhatsApp, Twitter, or LinkedIn.