GameStop mania explained: How the Reddit retail trading crowd ran over Wall Street pros

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A customer holds a GameStop shopping bag inside a store in San Francisco.
David Paul Morris | Bloomberg | Getty Images

Wall Street has been watching GameStop in awe as a band of Reddit-obsessed retail investors managed to push the stock up 1,500% in two weeks, squeezing out short-selling hedge funds.

A wave of at-home traders found each other on the red-hot “wallstreetbets” Reddit chat room, whose members have ballooned to over three million. By motivating each other to keep piling into shares and call options, they coordinated a monstrous short squeeze in the brick-and-mortar video game retailer.

“Retail investors with the help of technology acting as a union in attacking is a new phenomenon,” said Jim Paulsen, chief investment strategist at the Leuthold Group.

“You combine the power of technology, which allows you through Reddit postings to magnify your individual impact, with some use of leverage and very targeted bets, they can have a significant influence, particularly on areas of vulnerability because of the short positions,” Paulsen said.

Many enthusiastic Reddit users have been posting screenshots of their brokerage accounts, some of which touting astronomical returns north of 1,000% in a handful of days. These passionate investors often call out short sellers in the chat room in colorful language and unpleasant internet memes.

“This is gaining cult-like status,” said Quincy Krosby, chief investment strategist at Prudential Financial. “It is a pack of traders and the pack is gaining momentum. The retail crowd is not just taking over the shorts and it’s taking over the headlines.”

The intense speculative behavior among retail investors is unnerving many on Wall Street as mounting losses by hedge funds could spill over to other areas of the market. Some also believe this buying frenzy could be an ominous sign for a market at record highs.

“It could potentially destabilize the overall market and the confidence in the market. Those who have not joined will be compelled to join,” Krosby added.

These amateur investors have started targeting other heavily shorted names including AMC Entertainment and Bed Bath & Beyond, leaving Wall Street analysts’ targets in the dust.

How does short-selling work?

A short seller borrows shares of a stock and sells these borrowed shares to buyers willing to pay the market price. As the stock price falls, the trader would buy it back for less money, pocketing the difference.

However, when the stock jumps sharply higher, it forces short sellers to buy back shares in order to limit their losses. The short covering tends to fuel the stock’s rally further.

The rally in GameStop was initially triggered on Jan. 11, when news broke that activist investor and Chewy co-founder and former CEO Ryan Cohen is joining GameStop’s board. The stock jumped on the announcement on hopes Cohen would drive a change in strategy.

GameStop continued to rocket higher as retail traders showed no signs of letting up. Amid the massive squeezes, Melvin Capital closed out its short position in GameStop on Tuesday afternoon after taking a huge loss, the hedge fund’s manager told CNBC’s Andrew Ross Sorkin. Short seller Andrew Left of Citron Research said Wednesday he has covered the majority of his short position in GameStop at a loss.

GameStop was the single most traded name in the U.S. stock market on Tuesday, topping even megacap companies like Tesla and Apple, according to Deutsche Bank.

Options supercharging the squeeze

Many avid Reddit posters hyping up GameStop are buying call options, a type of derivative contracts that give the holder the right to buy the underlying security at a stated price within a specific timeframe. The call options contract values can surge by even larger magnitudes when the underlying stock is rallying by 100% a single day. Options trading has become accessible and easy to millennial investors, thanks to those new and commission-free apps such as Robinhood.

“This is all a part of the democratization of the market,” Krosby said. “Normally when we are talking about levering up and options, it typically is associated with investors, professional managers, and hedge funds.”

When retail investors looks for cheap upside calls, it leaves the sell-side or the market makers who are the middlemen in the transaction short a lot of upside calls, or short gamma. As the stock rises towards those strikes, the market makers need to buy increasingly more stock to hedge their short calls. This effectively accelerated the rally further in GameStop and other heavily shorted names.

“Retail order flow in the options are essentially supercharging the short squeeze, like the tail wagging the dog,” CC Lagator of Options AI said. “That gamma effect adds buyer after buyer in the stock, with no one able to short the stock because it is hard to borrow. The effect is a massive short squeeze.”

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