How GameStop Stock Became Hedge Fund's Worst Nightmare After a Reddit-Driven Frenzy Explained

GameStop may well be a nondescript struggling chain of video game retail stores in the US, but if its stock price is anything to go by, then it is definitely more in demand than the hugely popular Facebook, Apple, Amazon, Netflix and Google group of stocks that has even made Indians look at the US stock market for investment opportunities. Shares of GameStop have surged from $19 on December 31, 2020, to $197.84 on January 27 a gain of nearly 1,900 per cent.

How did this begin?

It all started when well-known hedge funds like Melvin Capital and Citron Research got interested in GameStop shares. These funds are known to target stocks that they feel are overvalued by going short on the shares. Short selling or short sellers are those who borrow shares and sell while hoping the price would fall further so they will be able to buy the shares at a lower price and return the shares to the lender. Short selling is a widely accepted practice and is allowed in most of the markets across geographies.

incidentally, the Indian markets also offer the Stock Lending and Borrowing mechanism, or SLB, for better managing the settlement of short selling trades.

In the case of GameStop, the hedge funds had played their cards and were waiting for the shares to fall and make a killing. They had no idea that an online group on Reddit, where members exchange tips and stock ideas would put a spanner in their plan and the wound would be so deep that they would end up staring at bankruptcy.

The group members decided to use the most lethal weapon that one can use against short sellers the short squeeze.

What is short squeeze?

Essentially, on the stock market, you can bet on a share price falling rather than rising, by borrowing shares and selling them at the current price, with the obligation to buy them at a later date, at whatever price they have then reached. GameStop, before the frenzy, was one of the most shorted shares on the US market, as a range of funds bet that it would slump during the pandemic.

Short squeeze is a term used by market participants to refer to a phenomenon where short sellers in a stock who have placed their bets on a stocks fall, rush to hedge their positions or buy the stock in the event of an adverse price movement, in order to cover their losses. This leads to a sharp rise in demand for the share, and huge rally in share prices.

A series of users on the forum Wallstreetbets noticed that GameStop was undervalued by the market and vulnerable to a short squeeze. GameStops low share price made it relatively easy for a large number of people to buy in with little money. As the share price rose and rose, more people bought in both to trigger the short squeeze, and because the price itself was now a way to make money.

Required

Briefly discuss the concept of the efficient of market hypothesis , behavioural finance and adaptive markets hypothesis with respect to the GameStop debate (40 marks)