Swimming Naked with GameStop

Submitted by Guy Williams on March 8, 2021

The legendary investor Warren Buffett once said, “You only learn who has been swimming naked when the tide goes out.”

 

I must admit that I did not really give this much thought until recently due to the sudden rise and fall of GameStop.

 

GameStop is a retail store that buys and exchanges used video games and phones. You may shop at one of the two GameStop locations in Kenner. The stock is usually not a highflyer, meaning a high-priced and very risky stock. It normally trades between ten and twenty dollars per share. The company, like many retailers, did not make any money in 2020 and was only marginally profitable over the last few years.

 

Yet a few weeks ago, the stock surged to almost $483 per share before plunging to $285, and then the stock resurged to $356 before plunging once again.

 

The explanation lies in the confluence of three unrelated events. The first event was the widespread adoption of the Robinhood free stock trading platform, which allows very low minimum investments. The second event was the widespread economic shutdowns combined with stimulus checks and extra free time. The final event was the rapid spread of social media chat groups and forums, such as Reddit, devoted to day trading and short-term investing.

 

These trends together caused a large number of new inexperienced investors to open Robinhood trading accounts and deposit their stimulus checks, and then they began to look for ways to invest the money.

 

Meanwhile hedge funds and big investors were expecting GameStop stock to fall in value as most retailers had, so they sold the stock short. Selling a stock short occurs when you ask your broker to borrow a share of stock from an owner and then sell that stock and pocket the cash.

 

If the stock price goes down, you buy the stock back for less than your sales price. Afterwards, you return the stock to the owner while keeping the difference as your profit. If the stock goes up, you must buy it back at a higher price than your sales price, and consequently you lose the difference.

 

The risk with short selling is that sometimes the stock can go up substantially more than the price you received when you sold the stock. Your losses can greatly outweigh what you received in the original sale.

 

What made GameStop interesting is that more than one hundred percent of all of the GameStop shares were sold short at one point. Chat boards quickly recognized this and discussions began. They knew if many small investors bought the stock and pushed the shares higher, the short sellers would need to pay almost any price to cover their short positions.

 

Strong buying in a thin market pushed the shares to extremely high prices that were completely unconnected to the value of the company. Ultimately, the short sellers were indeed squeezed and were forced to pay high prices, but only once, to cover their short positions and then close.

 

Swimming naked means selling shares that you don’t control and did not borrow. If the stock price surges, a naked short seller may end up paying a very high price to cover the shares sold or be forced into bankruptcy. GameStop revealed many naked swimmers.

 

With extraordinarily little, short interest in GameStop now, the stock will most likely be traded based upon its value as an unprofitable retail store. This might tempt some brave short sellers to try to bet again. However, remember betting is just betting, not investing. Moreover, if you still own GameStop, you are holding a low-quality stock at a relatively high valuation.

 

Bank investment accounts are a great way to build net worth, but keep in mind that betting on volatile stocks can be even more risky than going to the casino.