Gamestop Hedgefund Controversy Explained

Gamestop's stock price rose 400% in January 2021, making it one of the fastest-growing stocks in history.

This sudden surge was largely driven by a group of retail investors, who banded together to take on the hedge funds that had shorted the stock. Short selling involves betting against a stock's value, and the hedge funds had wagered that Gamestop's stock would continue to decline.

The retail investors, however, had a different plan. They used online platforms to buy up shares of Gamestop, driving up the stock price and causing the hedge funds to lose millions.

The GameStop hedge fund controversy is a fascinating tale of how retail investors took on the big boys and came out on top. GameStop, an American chain of brick-and-mortar video game stores, had struggled in the years leading up to the short squeeze due to competition from digital distribution services and the economic effects of the COVID-19 pandemic.

Retail investors, especially those vocal on Reddit, began saying the GameStop stock was undervalued. Their bullish outlook pushed the stock price up and attracted attention from institutional investors. But these institutional investors had a different idea. After performing fundamental analysis, they decided that GameStop was still dead meat, and started short selling shares of GameStop stock.

The short selling strategy involves borrowing stocks and then selling them at market price, with the intention of repurchasing them at a lower price later. However, if the stock price does not fall, the short seller is in trouble. As the price rises, they will be in the red because they will need to repurchase the securities at a much higher price than what they sold them for.

The members of the reddit forum r/WallStreetBets had a different idea. Seeing that hedge funds were short selling GME, they hatched a plan to drive up the price. They held their shares and talked up a bullish perspective online, encouraging more people to buy GameStop stock. The stock price soared to $347.51 per share by the end of January, a whopping 1.743 percent increase from its price just a few weeks earlier.

The GameStop short squeeze cost hedge funds $19.75 billion in January alone. Most of these hedge funds are still experiencing fallout in one form or another. While some have slowly worked their way back to normative returns, others are down and out for good—at least until they discover fresh and willing sources of capital.

The influx of retail traders has forced hedge funds to change their tactics and manage their risk more carefully. After seeing Melvin Capital lose billions from shorting GameStop, many hedge funds now monitor financial discussions on Reddit and other social media platforms to see what’s bubbling. Some hedge funds have become more wary about shorting volatile stocks, in case they face a counter-movement from invigorated retail investors.

The big banks, like Citadel, were also winners in this game. Citadel earned a fortune from all this trading activity, even after accounting for their bailout. The other big winner was the tech private equity firm Silver Lake, which owned convertible bonds in bankrupt movie theater company AMC. It made a nice $713 million after another short squeeze made AMC’s stock price rise 10x.

The Ontario Teachers’ Pension Plan also made close to $500 million selling stock in a shopping mall owner (Macerich Co) following a similar squeeze. But if you want, please ignore all the evidence and keep believing that these short squeezes represent David beating Goliath.

Hedge funds are companies that manage assets contributed by accredited investors, who have a net worth of over $1 million or an income of over $200,000 per year. These investors can invest however they want, leveraging strategies beyond the simple buying and selling of stocks or bonds.

One of the strategies hedge funds use is short selling, where they borrow stocks and sell them at market price, hoping to buy them back later at a lower price. However, if the stock price rises, they'll be in trouble, as they'll need to repurchase the securities at a higher price.

Retail investors, on the other hand, were also affected by the GameStop short squeeze. Many of them bought shares of GameStop and other affected securities as they were reaching their peak prices or shortly afterwards, but ultimately suffered significant losses.

Some hedge funds, like Melvin Capital, were heavily affected by the short squeeze, losing 49% of their investments in the early months of 2021 and requiring a $3 billion bailout.

Here are some of the hedge funds that were affected by the GameStop short squeeze:

These losses highlight the risks involved in short selling and the importance of careful investment strategies.

Melvin Capital, a London-based hedge fund, lost 49 percent of its investments in the first three months of 2021, forcing a $3 billion bailout from Citadel and Point72.

Citadel's market-making arm, Citadel Securities, processed 39% of all U.S.-listed retail volume, including a significant portion of GameStop trades.

Citron Capital, another hedge fund, suffered 100 percent losses on its GameStop positions during the retailer's bullish rally.

Candlestick Capital Management, an investment firm from Greenwich, Connecticut, saw percentage losses in the teens, a significant decline from its previous year's 26 percent return.

Melvin Capital was a London-based hedge fund that suffered greatly due to the GameStop short squeeze. They lost 49 percent of their investments in the first three months of 2021.

Their annual returns were impressive, reaching 30 percent between 2014 and 2020. This suggests they were doing something right, but it's clear they made a significant mistake in 2021.

In response to their losses, Citadel and Point72 provided a $3 billion bailout to Melvin Capital. This was a huge lifeline, but it ultimately wasn't enough to save the fund.

Melvin Capital was forced to shut their doors and return capital to investors. This was a major decision, and one that shows just how severe their losses were.

Citron Capital took a hit on its GameStop positions, suffering 100 percent losses during the retailer's bullish rally.

Maplelane Capital was heavily affected by the short squeeze, losing 33 percent of its $3.5 billion. This highlights the risks involved in options trading, even when done to minimize risk.

Maplelane's strategy centered around options trading, not short selling, which is a similar practice. This approach didn't protect them from the short squeeze's impact.

A put option is used when an investor thinks a stock price will fall, allowing them to sell it at an agreed-upon strike price. This type of option can be a good way to minimize risk when acting on bearish perspectives.

Despite the risks, Maplelane's experience can serve as a reminder that investing requires careful planning, strategizing, and networking. This is especially important for those looking to build long-term wealth.

Candlestick Capital Management is an investment firm based in Greenwich, Connecticut. They saw percentage losses in the teens, according to several sources.

Their previous year's performance was a 26 percent return, which makes their recent losses all the more striking.

Citadel earned a fortune from the GameStop short squeeze, even after accounting for their bailout, which was worth $3 billion from Citadel and Point72.

The market-maker's goal is to make money with the bid-ask spread and commissions, regardless of the stock price movement.

Citadel routes more than 50% of Robinhood's orders through their market-making arm, and they pay Robinhood for this "order flow".

The Ontario Teachers' Pension Plan made close to $500 million selling stock in a shopping mall owner (Macerich Co) following a similar squeeze.

Silver Lake, a tech private equity firm, made a nice $713 million after another short squeeze made AMC's stock price rise 10x, allowing them to convert their convertible bonds into equity.

The events around GameStop had a one in 3.5 million chance of occurring, according to CEO Vlad Tenev of Robinhood.

GameStop's stock price declined substantially on February 1 and 2, losing more than 80 percent of its value from its intraday peak price. This decline was partly due to restrictions imposed by Robinhood and other brokers on the number of shares that could be purchased at once by their clients.

The stock price of GameStop shares lost 60 percent of their value on February 2, closing below $100 for the first time in a week. Reports estimated that about $27 billion in value had been erased.

Other assets affected by the short squeeze and put under company trading restrictions, such as AMC and BlackBerry shares, also declined in value. However, the decline in value didn't stop amateur traders from rallying to convince other users to hold on to the shares, arguing either that they would increase in value or that such an action would send a political message.

Here's a list of the stocks that experienced sharp price increases during the short squeeze:

On March 24, the GameStop stock price fell 34 percent to $120.34 per share after earnings were released and the company announced plans for issuing a new secondary stock offering worth up to $1 billion.

The GameStop hedge fund saga has raised a lot of questions about regulatory and legal issues.

The U.S. Securities and Exchange Commission released a sample letter in February 2021, requiring companies to outline related risks in their financial disclosures and encouraging companies to contact the SEC prior to launching offerings during periods of extreme price volatility.

Several Democratic politicians have expressed support for a financial transactions tax, arguing it would raise revenue and curb speculative betting.

A 140-page report released by the United States House Committee on Financial Services in June 2022 called for the Securities and Exchange Commission and the Financial Industry Regulatory Authority to craft new rules to address market risks highlighted by the events of January 2021.

Congressional hearings were held in February and March 2021, where representatives grilled Robinhood's Vlad Tenev and Citadel's Ken Griffin on issues such as payment for order flow and gamification of investing.

A Robinhood customer filed a class-action lawsuit against the company in federal court on January 28, 2021, for halting trading on GameStop, claiming that Robinhood "purposefully, willfully, and knowingly removing the stock 'GME' from its trading platform".

The Judicial Panel on Multidistrict Litigation consolidated several lawsuits in the Southern District of Florida under the caption IN RE: January 2021 Short Squeeze Trading Litigation.

The U.S. Securities and Exchange Commission announced it was reviewing the incident with the aims "to protect retail investors" from "abusive or manipulative trading activity" and "to identify and pursue potential wrongdoing" in January 2021.

The investigations into the GameStop short squeeze were swift and widespread. The White House press secretary, Jen Psaki, announced that Treasury Secretary Janet Yellen and others in the Biden administration were monitoring the situation.

Several government agencies, including the U.S. Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Reserve, convened a meeting to discuss the volatility surrounding the short squeeze. This meeting was necessary because of concerns about systemic risks.

The U.S. Securities and Exchange Commission announced it was reviewing the incident to protect retail investors from "abusive or manipulative trading activity" and to identify and pursue potential wrongdoing. This review aimed to ensure that investors were treated fairly and that no laws were being broken.

Attorney General of New York Letitia James confirmed that her office would look into the matter, saying "We are aware of concerns raised regarding activity on the Robinhood app, including trading related to the GameStop stock." This investigation was likely to examine whether any laws were being broken.

Texas Attorney General Ken Paxton also announced an investigation into the decision of brokerages to limit the buying of securities related to GameStop and other stocks, saying that it "stinks of corruption." This investigation has extended to 13 entities, including Discord, Robinhood, the trading platforms Interactive Brokers and TD Ameritrade, and Citadel Financial.

As a result of these investigations, several class-action lawsuits were filed against Robinhood and other companies involved in the short squeeze. These lawsuits claimed that the companies had manipulated the market and deprived retail investors of their rights.

The U.S. Securities and Exchange Commission released a sample letter on February 8, 2021, providing guidance to companies seeking to raise capital during periods of extreme price volatility.

In this letter, the SEC required companies to outline the related risks in their financial disclosures and encouraged them to contact the SEC prior to launching such offerings.

Democratic politicians have expressed support for a financial transactions tax, arguing that it would raise revenue and curb speculative betting.

However, regulation hasn't materialized yet, despite the GameStop craze bringing regulatory scrutiny to the world of short-selling.

Several bills were drafted in Congress, including Maxine Waters' Short Sale Transparency and Market Fairness Act, but did not advance.

The Securities and Exchange Commission proposed reforms to securities markets in December 2021, but actual reforms have yet to come into effect.

The SEC's Chair Gary Gensler pledged to drive greater efficiencies, particularly for retail investors, in the wake of the meme stock craze.

Congressional hearings were held to discuss the GameStop incident, with the House Financial Services Committee holding a remote hearing on February 18, 2021, titled Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide.

The hearing featured witnesses including Reddit user and investor Keith Gill, Citadel CEO Ken Griffin, and Robinhood CEO Vlad Tenev, who were questioned about Robinhood's role in the event and its business model.

The committee members expressed skepticism at the practice of payment for order flow and pressed Griffin and Tenev on the issue.

Representative Brad Sherman accused Griffin of trying to evade his questions, and Gill made references to memes during his testimony.

The Financial Services Committee held a second hearing on March 17, 2021, which focused on the regulation of payment for order flow and gamification of investing.

The White House, led by Treasury Secretary Janet Yellen, was monitoring the situation, and a meeting of financial regulators was convened to discuss the volatility surrounding the short squeeze.

The regulators were not seen as likely to view the volatility as creating any systemic risks, but Congress and state attorneys general launched investigations into the incident.

The U.S. Securities and Exchange Commission announced it was reviewing the incident to protect retail investors from abusive or manipulative trading activity.

Attorney General of New York Letitia James and Texas Attorney General Ken Paxton also launched investigations into the matter.

Retail investors took a significant risk by buying shares of GameStop and other affected securities at peak prices or shortly afterwards. Many suffered significant losses, with some r/wallstreetbets users losing a majority of their savings.

Retail investors were encouraged to hold onto their long positions, but this often led to further losses as the stock prices continued to decline. Mark Cuban even encouraged GameStop buyers to hold on to their stock if they were able to in an "ask me anything session" on r/wallstreetbets.

The rise of everyday traders has been a notable impact of the GameStop event, with many novices opening brokerage accounts on platforms like Robinhood and TD Ameritrade. However, this has also led to a spread of financial misinformation, with 80% of millennials and Gen Z getting financial advice from social media.

The rise of everyday traders is a phenomenon that's been sparked by the GameStop craze, making the stock market more accessible to people who had never cared about or understood it before.

Most stock trading is still done by professional traders, but seeing the rise of GameStop's stock gave novices an impetus to open brokerage accounts on platforms like Robinhood and TD Ameritrade.

Activity on Stocktwits, a finance-centric social media company, had to expand its infrastructure by 10 times just to keep its servers up and running during the GameStock craze.

Now, Stocktwits has hundreds of thousands of daily active users who continue to use the site to share information and predictions.

Retail traders still account for 23% of market orders, which is nearing an all-time high, according to a JPMorgan strategist.

Those who have stayed in the market have kept learning, as noted by Rishi Khanna, CEO of Stocktwits, who says that there's been a permanence of a mentality change.

Retail traders are not winning, despite the hype surrounding the GameStop craze. Many retail investors suffered significant losses, with some r/wallstreetbets users losing a majority of their savings.

The GameStop craze highlighted the risks of trading, with many investors buying in at the top and losing thousands of dollars. Dumb Money notes that people were ill-informed on what to do, leading to costly mistakes.

The axiom is that trading is generally a losing process, and experts warn against over-trading. Don't jump in and out of the market based on news, and be aware that everything doesn't always go up.

Financial misinformation spread rapidly on social media, with 80% of millennials and Gen Z getting financial advice from platforms like TikTok. Some of this advice is well-researched, but much of it is not.

Bad information from biased actors continues to propagate, even from well-intentioned sources. It's essential to be cautious and do your own research before making investment decisions.

Reddit investors were able to band together to "stick it" to institutional hedge funds during the GameStop Short Squeeze.

The event was a great parable for illustrating how the stock market does not always reflect reality.

Citadel, a market-maker, earned a fortune from the trading activity, even after accounting for their bailout.

The market-maker's goal is to create as much trading activity as possible to make money with the bid-ask spread and commissions.

Silver Lake, a tech private equity firm, made a nice $713 million after another short squeeze made AMC's stock price rise 10x.

The Ontario Teachers' Pension Plan also made close to $500 million selling stock in a shopping mall owner (Macerich Co) following a similar squeeze.

These big winners show that even though retail investors may feel like they're beating the system, the market is still stacked against them.

The GameStop Short Squeeze may have been a victory for some, but it's also a reminder that the market is unpredictable and can be manipulated.