The Rise of Gamestop: A Short Squeeze Story

GameStop is an American video game retailer, based in Texas. In early 2021, something entirely unexpected happened with GameStop stock. The price of the stock (GME) rose more than 60 times in a matter of weeks, from single digits to more than $300 per share.

But this price rise did not happen because the company made a revolutionary announcement or roped in Warren Buffet as an investor suddenly. This phenomenal rise happened because of a short squeeze, something that punishes short sellers.

We talked about short selling in this article, and I said how short sellers are viewed as preying on weak companies, so let’s talk about how these guys are punished if and when they’re wrong. Just briefly, short sellers sell stocks at price and buy them back for price B. Their hope is obviously that A > B so that they are essentially buying low and selling high.

So what exactly are short squeezes? A short squeeze is an exceptional circumstance that causes the price of a stock or some other security to rise quickly. It happens when many investors are betting on a security's price to fall and there are a lot of short sellers of that security. The short squeeze starts when a sizable portion of the short sellers decide to cut their losses and quit their positions, causing the price to gain even more momentum to the upside.

Let’s say a company has a total of 100 shares in the market. You short sell 40 and I short sell 40. We’re waiting for the price to fall. What instead starts happening is that demand for the stock starts to rise and the price starts to go up. I panic and buy back 40 shares in the open market to stop my losses from getting bigger, and the demand for the limited number of stocks increases manifold due to me. So naturally the price goes higher. This price rise also attracts new buyers looking to ride the trend.

Now, you decide to buy back your 40 shares too because your loss is also getting too much for you, the same thing happens and you also increase the price due to the demand to buy. In essence, new buyers and panicked short sellers push the price higher and higher.

A very famous example of this type of circumstance is the GameStop one. During and after the pandemic lockdowns, analysts and investors anticipated that the company might go bankrupt due to increased competition and a drop in foot traffic at brick-and-mortar stores. Short sellers started to target GME stock. In fact, the short interest had risen to more than 100% of the outstanding shares.

But how can this happen? Well, if an investor owns shares of stock A, their broker can lend those shares to short sellers. These people can then resell the shares, which could be purchased by an investor, whose brokerage could lend them out to short sellers once again.

Getting back to the story, Michael Burry (of The Big Short fame) had developed a bull case for this company saying it could be profitable in a couple of years. This was posted in Reddit forums and on YouTube channels and a lot of investors started buying the stock late in 2020. This eventually led the big institutions (the short sellers in this case) to buy back and the exponential rise of the stock price.

And this was one of the very few examples where maybe the little guy overcame the big guys in the financial markets. Anyways, thanks for reading! And while that’s it for this article, you can more articles from me here. And do let me know if you want a specific topic covered! Subscribe for free to receive more posts like this every day!