What the Heck is Going on With GameStop?

We explain what a short squeeze is and how it works

Karen Wallace 27 January, 2021 | 5:36PM
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Squeeze

GameStop'
s stock has exploded over the past few days. After trading below US$ 20 per share for most of December and the first few weeks of January, it’s now trading at well over US$ 300 per share.   

And it’s not just GameStop--it’s also movie theater chain AMC and clothing retailer  Express, among other stocks with (ahem) ailing prospects. Why are these stocks suddenly soaring? The coronavirus pandemic has wreaked havoc on movie theaters’ profits as well as those of brick-and-mortar retailers. There wasn’t much positive news from these companies or fundamental reasons for the increased demand for these stocks. 

So what’s happening? It’s a classic short squeeze, but this time, Reddit-style.   

How and Why Do Investors 'Short' Stocks?
When someone shorts a stock, they’re trying to sell something that they don’t actually own because they think they can make money later by buying it back at a lower price. Hedge funds do this a lot, but short-selling can be very complicated and risky for individual investors to attempt.

Here’s how it works: If you believe a stock’s value will increase over time, you want to buy it and hold it, which is known as taking a “long” position. But if you anticipate that a stock’s price will decrease, you could take a “short” position. To do this, you would borrow shares of the stock and sell them to another investor (even though you don’t own them). If you can sell the stock to that new investor for a higher price than what it will cost you to purchase the shares from the original owner to cover your borrowing, you will profit from short-selling.

If the stock’s price keeps rising, though, the short seller will have to repay the borrowed shares at a higher price than they sold the shares for. Because stock prices can (in theory) rise indefinitely, short-selling can lead to potentially unlimited losses. With a long position, by contrast, an investor’s potential gains are unlimited but the most you could lose is 100% of what you invested.  

What’s a 'Short Squeeze'? 
A short squeeze can happen when there is enough increased demand for a stock that also has a lot of sellers making short sales (in other words, it has a high short interest ratio). That perfect storm of technical factors can push stock prices into the stratosphere--people are buying the shares, which forces the short sellers to buy the stock in an attempt to cut their losses. So, everyone is buying--the long buyers and the short sellers. And often a stock with a troubled future that attracts a short seller will not have a lot of trading volume, so small changes in demand can move the price quickly. 

What Happened With GameStop?
GameStop had been struggling along with other retailers for years, even before the pandemic hit. Morningstar classifies the small-cap value stock as distressed, meaning it has serious operating problems and should be considered highly speculative. A look at its profitability metrics is sobering. 

There were a lot of institutional investors betting that GameStop would go the way of BlockBuster. Notably, as of Dec. 31, 2020, the short interest as a percentage of the float for GameStop was 260%. So, there were many more people shorting the stock than there were shares available in the market. This is the perfect environment for some goofy trading to happen.   

Exhibit 1
  - source: Morningstar.com

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

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Karen Wallace

Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.

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