Understanding the GameStop saga even if you don’t understand the stock market

When it comes to financial literacy and personal wealth, it’s crucial to understand the importance of investing in the stock market. 

Michael Craighton


When markets opened for the new year on Jan. 4, most Wall Street investors expected that GameStop, a largely mall-based video game retailer struggling against the duel headwinds of already-dying mall retail spaces and a pandemic that has further depressed in-person shopping, would be the subject of nothing but bad headlines. Many firms, in fact, had made bets against the company, some of them very large. 

What followed was a nearly 2,500 percent rise in the company’s share price, and one of the most sensational — yet, for many, largely incomprehensible — stock market sagas in recent history.

GameStop’s rapid and extreme rise and fall has been called the “biggest short squeeze in 25 years,” according to the investment firm Goldman Sachs. But in order to understand what made the story so unusual, it’s important to understand how the stock market was designed to, and traditionally has, worked.

“It’s designed to be an efficient market,” said Tyler Jensen, assistant professor of finance at Iowa State University. 

Stocks, also known as equities, represent small pieces of ownership in the company issuing them. Companies initially issue shares of stock as a way to raise money for expansion or other large expenses. Once these shares are issued, investors buy and sell them in the stock market, a secondary market, seeking to profit from the change in the stock’s value. 

The value, or share price, of a stock is typically derived from what investors, often called traders, believe to be the fundamental value of the company, based on their expectations for the company’s future performance. The supply of people wanting to sell shares because they think the value will go down, matched to the number of people wanting to buy shares because they think the price will go up, ultimately sets the share price, although that price changes as the size of those two groups of people change.

“If you own a share of stock in Apple, you own one tiny little piece of that corporation,” Jensen said. “If Apple were split up into pieces and the [company’s] value divvied up, the stock price would accurately reflect that.”

By contrast to the usual method of trading in the stock market, where an investor buys a stock they think is undervalued and then sells it when the price goes up, some more sophisticated traders, such as hedge funds, take what are known as short positions. Taking a short position is essentially betting that the price of a stock will go down.

Fundamentally, to short a stock, a trader will borrow shares of stock from someone else and sell those shares while the price is relatively high. When the price of the stock drops, the trader will buy those borrowed shares back at the lower price and return them to the person they borrowed them from. Since they sold them for more than it cost to buy them back, they get to keep the extra money.

“On average, an average [company’s] stock has maybe five to 10 percent of its outstanding shares shorted,” Jensen said. Jensen highlighted that Apple, a company very few expect to decrease in value, has only half a percent of its total shares shorted.

The vast majority of these traders have traditionally been professional investors working for large brokerage firms. By contrast, and one factor that made the GameStop saga different from past short squeezes, was the centrality of the individual day trader in the rise of the company’s stock price.

“The average day trader/retail investor, think about these people as individuals who try to make money in the stock market on usually a short-term basis,” Jensen said. “A retail trader is just one person, a single individual, doing this as a hobby. Sometimes as a full-time job, but it’s just one individual.”

Day traders are a separate group from people who invest part of their paycheck in the stock market to save for retirement, Jensen said. Instead, day traders try to profit by making trades based on what they feel is better information or recognizing patterns they think other people have missed. 

Smartphone-based trading apps especially appealed to a younger demographic of traders, Jensen said. It provided a stock market experience on a platform they were familiar with and allowed them to trade stocks while they were also engaged with social media and other things.

As the country went into coronavirus lockdown in the spring, many people bored at home with little to do turned to the stock market and day trading for entertainment. 

“Everyone needs a hobby,” said Peter Orazem, an economics professor at Iowa State. “This sort of investing is looking for short-term gains…to get into the market and out before the market bursts.”

With the growing number of people entering the market, largely lacking the analysis resources enjoyed by large firms to find good investment targets, online communities began forming.

On the social media website Reddit, in a subreddit called r/WallStreetBets, users cheered each other’s gains and consoled each other for losses, traded investment advice and savvy analysis and combined stock tips and memes in a way that could only come to exist in an online subculture.

“It was always pretty rowdy. Kind of like ‘Wolf of Wall Street,’” said reddit user Grapefruit-God, an Iowa State student who’d been active on the subreddit for almost a year. “People talk shit and just say the most ridiculous things they can when they gamble their money on stocks from memes.”

GameStop, a company whose nearly ubiquitous mall-based video game stores occupied a place of nostalgia for many millennial and Gen-Z traders, saw its stock price dip as low as $3.90 in fall of 2020 amid the pandemic. A letter to the company’s board of directors anonymously posted on WallStreetBets initially drew the attention of the community’s users to the company. When Ryan Cohen, former CEO of the online pet food retailer Chewy.com, was named to GameStop’s board of directors, the company’s stock price began to climb as some investors hoped a pivot to the online marketplace could right the retailer’s fortunes.

Meanwhile, hedge funds had taken notice, with many of them believing GameStop’s trajectory as a failing mall retailer couldn’t be reversed. In the lead up to the new year, the company’s short ratio, the percentage of shares shorted to shares issued by the company, reached over 100 percent, meaning more shares had been shorted than actually existed. 

This extremely high ratio persisted into January when WallStreetBets, both believing the stock was undervalued and seeing the shortage of shares caused by the large short positions taken by the hedge funds, began encouraging users to buy the stock and drive up the price.

“All of these shares were already borrowed and already committed to short sale,” Jensen said. “So when the retail trade started ramping up based on social media pressure to buy GameStop stock, all of these shares were already committed, causing the price to go up.”

In this situation, the stock market works similarly to an auction house. More buyers than sellers means that those willing to sell can ask higher and higher prices, and the buyers agreeing to those prices will continue to encourage the prices to rise even more.

“Short sellers were forced to either unwind their positions or come up with extra capital to reinforce their positions,” Jensen said. 

Unwinding a short position requires a hedge fund to buy back the stock that it previously borrowed and sold. With the share price rising as high as $483 dollars during trading on Jan. 28, this forced some hedge funds, such as Melvin Capital, to take huge losses and nearly collapse.

Hence the “squeeze” in short squeeze. Traders organized on social media were able to buy up shares of GameStop when the availability of shares was low, driving up prices and “squeezing” the ability of hedge funds to weather the financial chaos.

Prior to the memeification of GameStop, WallStreetBets had been a very supportive community that didn’t take itself too seriously.

“Everyone that is there loves to be there and had no illusions as to what they’re doing,” Grapefruit-God said. “The whole GME [Gamestop’s stock symbol] is wayyy [sic] different.”

As public and media fascination with the saga began to rise, drive to take part in trading began to spill out of WallStreetBets and into the wider sphere of social media. Posts on other subreddits and Twitter calling on other users to “buy GME” and send it “to the moon” with the rocket ship emoji added fuel to frenzy. Social media users boasted about claims to have bought high, typically a position a trader tries to avoid, and encouraged others to “hold the line” and not sell their shares in attempts to continue to keep the share price inflated.

Beyond the realms of WallStreetBets and the frenzy on much of social media, other hobbyist day traders, such a Joe Noble, a senior in management information systems at Iowa State, were both caught up in and by the rapid price changes and high energy of the moment.

“I kind of noticed separately,” Noble said. “I saw GME was at $25, so I purchased some shares. Then the next day I saw it hitting at $60.”

Noble said he bought more shares as the price increased and went along with the idea of holding, but ultimately ended up selling at $70, taking a loss.

Different narratives have emerged for motivations of traders who jumped into the fray, ranging from a drive for profit to an anti-establishment statement. Regardless of one’s reason, both Jensen and Orazem cautioned that taking positions in the market in this way can carry significant risk.

“Everyone is allowed to make statements in whatever way they want, whether…political or whatever motivations,” Jensen said. “But be careful putting real financial wealth into an investment that you’re not sure has real fundamental value.”

Orazem cautioned that trying to time a market bubble and get out before it bursts is a risky strategy because prices aren’t set in the market the way they are in a store.

The stock market is also complicated and can be tricky for novice investors to navigate.

“Before all of this happened, I thought I was getting a grip on how it worked,” Noble said. “It’s definitely important to learn about the stock market if you’re going to invest. Don’t gamble with any money you’re not willing to lose.”

While it remains to be seen what will be the long-term social and cultural implications of social media’s realization of its collective ability to move markets, the upheaval of recent weeks has garnered the attention of regulators and government officials, including recently confirmed Treasury Secretary Janet Yellen and the Securities and Exchange Commission. 

As the hype and excitement move on to other bets, such as AMC, Nokia, silver futures and the cryptocurrency Dogecoin, Jensen said this can serve as a cautionary tale against trying to get rich quick in the stock market.

“When prices are driven away from their fundamental values, regardless of the reason for it, it often does not take them very long to reverse,” Jensen said.

If one’s reason for trading is political, seeking to make an anti-establishment statement against the behemoth institutions of Wall Street, Jensen has a more sobering takeaway.

“Even though there were financial institutions and hedge funds that likely lost a significant amount of money…the overwhelming majority of shares of GameStop were also owned by other financial institutions,” Jensen said. “The biggest winners were the institutions that originally held GameStop.”

The risk of loss remains unlikely to deter day traders and other investors from continuing to make bets in the stock market however.

“I would probably do it again,” Noble said. “For financial gain, now I know when to back out.”