The coordinated effort by users of the online forum Reddit to drive up the share price of GameStop and other companies is designed to turn the screw on short-sellers. To the layman, the dynamics at play here can seem really twisting.
In this case, Reddit users in a group called WallStreetBets noticed that hedge funds, including one called Melvin Capital, had taken a large short position in GameStop. They decided to punish the Wall Street big boys and launched a co-ordinated buying spree. That began forcing the price up – it is now up more than 1800% – increasing the losses for the short-sellers who had bet against it. They had suffered losses of $1bn already, according to reports on Thursday.
The hedge funds found themselves trapped in what is called a “short squeeze”, a kind of feedback loop that drives the price ever upwards. Short-sellers have been forced to buy back stock that they borrowed and sold because they need to return the shares fast or risk losing more money as the stock climbs higher, making their position even worse. Effectively they have been forced to bet on shares rising in order to offset their previous bet on them falling.
Hedge funds are not exactly the world’s favourite people, as they make huge amounts of money, often with ruthless disregard for the businesses. Several national financial regulators across the world imposed temporary bans on short-selling certain vulnerable stocks – such as banks or insurers during the post-2008 financial crisis – or even blanket bans on the practice.
The counter-argument is that you cannot successfully short a healthy company, as your bet will simply turn out to be wrong. Short-sellers can act as an early warning system highlighting bad businesses. They have often proved to be the first people to notice that a company is in trouble, sometimes even before the company’s directors do.