The Game-changing GameStop Short Squeeze

In late January, huge spikes in the stock price of GameStop, a struggling videogame retailer, grabbed the attention of the financial world. GameStop’s stock price has fluctuated between $20 per share to nearly $400 per share throughout the last month, amounting to a dramatic swing of over $20 billion in the company’s market capitalization. What made these volatile stock price movements unique was their catalyst: a group of retail investors communicating on platforms like Reddit, Twitter, and Discord were driving the stock price up and executing a short squeeze, thereby inflicting financial harm on hedge funds that had bet against the company.

Over the last year a number of prominent hedge funds aggressively built up short positions in GameStop, eventually leading to it being the most shorted equity in the world. Shorting a stock occurs when someone (a short seller) borrows shares of stock from another investor. The short seller then sells the stock at the current price with the expectation that the price will fall, allowing the short seller to later purchase the stock at a lower price and sell it back to the original investor at a profit. In other words, it’s a mechanism by which an investor can bet that a company’s stock price will decline.

When a large group of retail investors – primarily through the Reddit forum r/WallStreetBets – identified the large volume of short positions in GameStop, they began buying shares and orchestrating a “short squeeze.” A short squeeze is when the price of a heavily shorted stock increases, thus causing short sellers to purchase shares in order to minimize their losses. This subsequently creates a feedback loop that drives the stock price increasingly higher. In short (no pun intended), r/WallStreetBets successfully executed a short squeeze. As the company’s stock price skyrocketed, some of the large hedge funds that had shorted GameStop lost over 50 percent of their funds.

Many commentators, regulators, and politicians have questioned the legality of the Redditors’ online behavior and its effect on the broader market. When the price of GameStop stock was at its most volatile in January, the SEC released a statement declaring that the agency “will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws. Market participants should be careful to avoid such activity.”

Market manipulation can be prosecuted criminally by the Department of Justice or enforced through civil litigation by the SEC. Section 9(a)(2) of the Securities Exchange Act of 1934 prohibits “effect[ing] … a series of transactions in any security … creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.” According to recent reports, the SEC has been investigating whether social media posts advocating for other users to buy GameStop stock were part of a manipulative effort to drive up the share price.

Although regulators continue to investigate and gather facts, it seems doubtful that any strong legal case can be made against the retail investors. Online traders openly and transparently advocating to buy a stock likely doesn’t qualify as “a false or misleading appearance of active trading.” Further, there are numerous practical hurdles preventing regulators from cracking down. The r/WallStreetBets Reddit forum – which largely drove the initial GameStop price increase – has over 6 million users from around the world. Many of them have been using anonymous accounts, which further complicates the SEC’s ability to bring a market manipulation enforcement action.

“I think [the SEC is] going to struggle with it, and that’s why their statements have been so bland,” said Duke Law Professor Gina-Gail S. Fletcher in a recent interview. “They don’t really do a whole lot of market manipulation enforcement. It’s a really hard crime to prove. The statutory provisions and the case law related to it are all over the place, and they don’t favor the SEC.”

Going forward, large investors will likely be careful about shorting small cap public equities, such as GameStop or AMC. The prospect of online communities of retail traders sparking a short squeeze will now be on all professional investors’ radar. “This whole event is showing the power of large communities of everyday people,” said Reddit CEO Steve Huffman in an interview with the Wall Street Journal. “Not just massive institutional and professional investors get to participate in the stock market.”