Even if you don’t follow the stock market, there is a chance you have heard all about what happened with Gamestop on Reddit. So far, hedge funds and short-sellers have lost as much as $19.75 billion on GameStop stock. As surreal as it sounds, it’s also true. Short-selling is a popular technique that experienced investors use to rack up their gains. However, the Reddit Gamestop fiasco allowed small-time day traders to turn the tables on these investors and use the short-selling strategy against them.

You can call it brilliant or disastrous, depending on whose side you are on. The bigger question is, how did it happen? This article discusses what short-selling is and how Redditors were able to use it to their advantage to deliver heavy losses to hedge funds and short sellers.

What Is Short Selling?

Short selling is a strategy investors and traders use where they speculate on a stock’s price declining. They use a margin account and borrow shares to open a short position. The investor then bets the price of the borrowed shares will decline in the future. They sell these stocks to buyers who are willing to purchase them at market price.

An expiration date is set, by which time the investor buys back the borrowed shares and closes their short position. If the price of the shares declines, they can earn a profit on the difference. However, if the share price goes up instead, they incur a loss.

Since they open a margin account, short sellers also have to pay interest on the price of the borrowed shares until the position closes. Furthermore, a margin account must have a minimum amount of money deposited in it. This is called the maintenance margin, and if the value of an investor’s account dips below this margin, they need to insert more funds. If they can’t, the broker can sell their position.

How Did Short selling Backfire with GameStop and Reddit?

GameStop is an electronics retail company that sells video games, gaming merchandise, and consumer electronics. Given its declining performance in the past, many big-time investors had shorted GameStop’s shares, expecting its price to go lower.

However, retail investors on a Reddit group, the WallStreetBets, disagreed. Instead, they believed that GameStop’s shares were undervalued and started buying them up.

Of course, they didn’t do this on a whim. GameStop made an announcement that Ryan Cohen, an established investor, was joining its board of directors. Cohen had bought a 10% stake in GameStop last year. Two of his allies also joined the board of directors. These changes held promise for retail investors who believed that the company could still turn things around. Hedge funds and investment banks thought otherwise and shorted GameStop’s shares.  

It was then that a member of WallStreetBets noticed that the number of shorted shares for GameStop was actually greater than the actual shares available for trading. GameStop had entered into a “negative float” position. Who bought these shares? The Redditors did.

This meant that short sellers had no option but to buy back these shares and close their short position. They were already above 100% and had to buy the borrowed shares one way or the other.  

The problem? The retail investors refused to sell. In fact, the longer these traders held onto their shares, the more their prices increased. As a result, GameStop’s share prices showed a big jump. We aren’t talking about a 10% to 20% increase. Instead, it increased by more than 1800%! In 2019, its stock was priced at a meager $3.30 per share. However, a week ago, it was valued at $347.51 per share.

Do the math. If an investor borrowed shares at $4 (ignoring the interest rate) but had to buy it back at $300, they incurred a loss of $296 per share! These losses go even higher if you multiply this amount by the number of shares they originally borrowed.

Fun fact: WallStreetBets had over 2 million followers earlier. Thanks to the Reddit GameStop debacle, it now has over 5 million followers.

Which Hedge Funds Suffered the Most?

As mentioned earlier, investors that shorted GameStop’s shares collectively lost over $19 billion. Perhaps the most notable case here would be of Melvin Capital. The hedge fund closed its short position on 26^th January after incurring a considerable loss. It is not known how much money the hedge fund lost on its bet.

However, it has received $3 billion in a bailout by Citadel and Point72 to ensure solvency. That itself should be telling enough of the precarious position they were in.

What’s the Lesson Here?

The thing about short selling is that while it usually delivers high returns, you are also taking a great deal of risk. Since there is no limit to how much a share’s price can increase, the losses can be massive. That is exactly what happened with GameStop.

The story doesn’t end with GameStop either. Redditors are now targeting other undervalued companies such as Macy’s, BlackBerry, and AMC and promoting them to drive up their share prices.

Of course, GameStop’s shares are massively overvalued at the moment. Retail investors have created a bubble, which can’t last forever.

It’s not exactly sustainable, but it does teach a lesson or two.

You see, most retail investors didn’t hold onto their shares to make a lot of money. Instead, they wanted high-end stockbrokers and hedge funds to lose money instead. There are many threads on Reddit with members considering the Reddit GameStop incident as payback against big companies that were responsible for the Financial Crisis of 2008.

That said, a fair bit of money has been earned on these trades too. The GameStop trading has allowed its shareholders to earn over $2 billion. The biggest earners here are Cohen and the other two shareholders with the biggest stake in the company. However, some retail investors have also seen their portfolios increase rapidly in value. Many retail investors intend to donate their profits to charity, as well.  

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