GameStop Mania Defined: How The Reddit Retail Crowd Overtaken Wall Road Professionals

A customer holds a GameStop shopping bag in a San Francisco store.

David Paul Morris | Bloomberg | Getty Images

Wall Street watched GameStop in awe when a group of Reddit-obsessed retail investors managed to gain 1,500% in stock in two weeks and displace hedge funds short selling.

A wave of home vendors found itself in the glowing Reddit chat room “wallstreetbets,” which has risen to over 3 million members. By motivating each other to keep piling up in stocks and call options, they coordinated a tremendous brief pressure in the brick and mortar video game retailer.

“Private investors using technology to unionize attacks are a new phenomenon,” said Jim Paulsen, chief investment strategist at Leuthold Group.

“They combine the power of technology that enables you to increase your individual impact through Reddit postings. With a little leverage and very targeted betting, they can have a significant impact, especially on areas of vulnerability due to short positions,” said Paulsen .

Many avid Reddit users have posted screenshots of their brokerage accounts, some of which are advertising astronomical returns north of 1,000% within a few days. These ardent investors often call short sellers in the chat room in bright colors and awkward internet memes.

“It’s gaining cult status,” said Quincy Krosby, chief investment strategist at Prudential Financial. “It’s a group of traders, and the group is gaining momentum. The retail crowd is not just taking the shorts, it’s taking the headlines too.”

The intense speculative behavior of retail investors worries many on Wall Street as rising losses from hedge funds could spill over into other areas of the market. Some also believe this spending spree could be a threatening sign of a record high market.

“This could potentially destabilize the overall market and confidence in the market. Those who have not joined will be forced to join,” added Krosby.

These amateur investors have started targeting other heavily truncated names like AMC Entertainment and Bed Bath & Beyond, leaving Wall Street analysts’ targets in the dust.

How does short selling work?

A short seller borrows shares of a stock and sells those borrowed shares to buyers willing to pay the market price. If the stock price fell, the trader would buy it back for less and pocket the difference.

However, when the stock rises sharply, short sellers are forced to buy back shares to limit their losses. The short cover tends to drive the stock’s rally further.

The GameStop rally was originally sparked on January 11th when it was revealed that activist investor and Chewy co-founder and former CEO Ryan Cohen was joining GameStop’s board of directors. The stock jumped on the announcement in hopes that Cohen would drive a change in strategy.

GameStop continued to skyrocket as retailers showed no signs of easing. Amid the massive shortages, Melvin Capital closed its short position in GameStop on Tuesday afternoon after taking a huge loss, the hedge fund manager told CNBC’s Andrew Ross Sorkin. Citron Research short seller Andrew Left said Wednesday that he had lost most of his short position in GameStop.

GameStop was the most traded name on the US stock exchange on Tuesday and, according to Deutsche Bank, was even at the top of mega-cap companies like Tesla and Apple.

Options for charging the squeeze

Many avid Reddit posters dwarfing GameStop are buying call options, a type of derivative contract that gives the holder the right to buy the underlying security at a set price within a specified time period. Call options contract values ​​can increase by even larger amounts if the underlying stock increases 100% in a single day. Thanks to these new and commission-free apps like Robinhood, options trading has become accessible and easy for millennial investors.

“This is all part of democratizing the market,” said Krosby. “When it comes to leverage and options, it is usually associated with investors, professional managers and hedge funds.”

When retail investors are looking for cheap up calls, the seller or market makers who are the middlemen in the transaction leave many up calls or short gamma short. As the stock rises in the direction of these strikes, market makers will have to buy more and more stocks to hedge their short calls. This effectively further accelerated the rally in GameStop and other heavily shortened names.

“The flow of orders in the retail trade in Options essentially speeds up the short press like the tail wagging the dog,” said CC Lagator of Options AI. “This gamma effect adds buyers to buyers in the stock, and no one can short the stock because it is difficult to borrow. The effect is a massive short squeeze.”

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