Wanna know what’s really happening with the whole Reddit vs. GameStop stock vs. hedge fund guys drama? People are getting played, plain and simple.

It’s nothing new. Actually, it happens more frequently than you probably imagine. It happened in October of 2008 when hedge funds lost $30 billion during the (quietly) famous VW infinity squeeze. What’s different now? Regular people are gaming the system, and that’s apparently not okay with the folks over at Wall Street.

What happens when regular people game the system versus when it happened over a decade ago with Volkswagen? Nobody asked for a do-over years ago, so why did trading get shut down for GME stock?

The answer lies in who’s gaming the system and how they’re doing it. Reddit, Robinhood, AMC, and GameStop are making headline news for how they’ve thrown stereotypical finance bros into a frenzy. But does this mean that you should be running out to buy up GameStop stock? Not so fast.

If you haven’t seen The Big Short (definitely check it out), then you might need a bit more context to understand the situation at hand. Aside from hedge funds getting caught with their hand in the cookie jar, here’s what to know about GameStop stock, shorting, and whether or not it’s a good time to buy into the craze.

How Does Shorting Work?

Usually, people make money when they invest in a stock and sell it. That’s what normally happens. Wall Street sometimes plays the other side, though. They’ll make money on the decrease of the price in shares, which means they’re basically betting that something will fail.

Enter: GameStop. Everybody thought they were for sure going to go bankrupt, especially the hedge funds. Amateur investors on Reddit caught wind of this and saw it as a way to challenge Wall Street. So, they went in and purchased lots of stock so the price would rise. 

This is a short. Betting on the stock to lose in this context means borrowing a stock from a broker and selling it fast at its current price. What’s the point in that, right? 

People who do this are betting that the price will go down, so once they sell the stock, they’ll quickly be able to repurchase it at a lower price and then return those shares to the broker. They keep the difference and win in the long run.

This is what the Wall Street guys did with GameStop stock. However, instead of the prices per share going down as expected, a Redditor caught onto the game, noticed that a hedge fund had purchased tons of GameStop stock, and alerted the thread. 

Everybody on the thread started buying GameStop stock, which, in turn, increased the price, leaving the hedge fund guys out in the dark (and out billions of dollars...over $13 billion, to be exact). This is called a “short squeeze.”

Overall, shorting is a dangerous game, and GameStop is a brutal reminder of that. Professional investors short just so that it’ll reduce the impact of the whole market declining on their total portfolio of investments. But keep in mind that those are professional investors.

What is a Short Squeeze?

What we explained above is a short squeeze! When traders, or short sellers, bet that the price of a stock will drop and it doesn’t, they experience a short squeeze or a rapid increase in the price that forces (or squeezes) them to buy back their shares at a higher price to avoid even bigger losses.

This is what the hedge fund guys had to do with the GameStop stock. Once Redditors started purchasing shares and driving the prices up, the short sellers who’d banked on the prices dropping had to rush and buy up all their shares back. 

Is there a goal behind a short squeeze? In this specific instance, the goal was to squeeze the hedge fund into bankruptcy. Essentially, the goal was to beat them at their own game by playing by their own rules. Redditors have now started combing through other hedge funds with lots of similar stocks to try, and short squeeze them into bankruptcy as well. 

Now, amateur investors are wondering whether or not it makes sense to track these short squeezes and try to bet on them in the hopes of cashing out like they might have with GameStop stock (if they were lucky enough to get in before investing apps shut it down). 

How might they track stocks to see which ones are at risk of a short squeeze? By looking at something called “short interest.”

What is Short Interest?

Put simply, short interest is a way of identifying stocks at risk of a short squeeze.

To calculate short interest, you have to look at the number of shares that were sold “short” in relation to the total number of shares. For example, at one point in the last year, Tesla’s short interest rose to 18%, which means that 18% of the shares were sold “short.”

Experienced investors can take a look at the short interest rate and determine a lot of information, such as whether there has been a change in sentiment positive or negative and also whether it is ripe for a short squeeze. It bears mentioning that heavily shorted stocks are usually shorted for a reason. 

What Made GameStop Ideal for Short Selling?

For future reference, it helps to identify companies that are the ideal candidates for short selling. As you might see, GameStop was the perfect target. Usually, these types of companies have a few of the following attributes:

• They’re in a secularly-declining business: This means that the company’s entire business model is in decline. In this case, GameStop’s business model (retail video games) has been shifting to online downloads for years. In a secular decline, each year the trend is expected to get worse.
• Management has a history of over-promising and under-delivering: Generally, there is limited insider ownership.

Now, we challenge you to take a look at current stocks. Which types of companies do you think might currently fit the bill? Drop us a comment below to let us know!

GameStop is a Story Stock: What is That?

If all of this talk of GameStop stock, significant earnings, and squeezing Wall Street finance guys out of billions of dollars has you thinking that you’d like to engage in short selling and squeezing, then you might wanna learn a bit about story stocks first.

GameStop is a story stock, which means that the shares outperformed solely based on some bizarre innovation or worldwide news coverage. In this case, the stocks outperformed due to Redditors instead of pure business fundamentals in terms of income and assets.

If you’re asking yourself, “Yeah, but what does it matter as long as I win big?” then you might not get the game just yet. Buying stock on the uptrend and selling once it declines is the investment style described as momentum. 

We don’t recommend momentum investing unless you can spend most of your day watching your screen. 

The Dangers of Momentum Investing

When momentum stocks stop going up, there can be some spectacular declines as many investors look for the exit at the same time. As an example, GME’s -60% share price decline on February 2nd, 2021 is a perfect example of the dangers of momentum investing. Could you imagine...you go camping for a day and come back and you have lost 60% of your savings!

The fundamentals of a company and its long-term performance in the market are a lot more important than any momentary market surges like the one that happening now with GameStop. GameStop stock’s sheer volatility means that it’s not wise to invest in it at the moment, regardless of how peer-pressured you feel online.

Let’s put this into perspective. It’s so volatile that, on any given day, the stock could be up 50 to 100%, but because you bought at the wrong point in the day, you could potentially lose up to 30, 40, or 50% in one day. That’s not smart investing.

Okay, okay, we hear you asking, “But what about investing a small amount of cash to avoid bigger risks?” Yeah, that’s great, and all, and you’re right that it does reduce the risks, but it doesn’t often lead to the best outcomes. Let’s say it works. Now, you’re left with a gain so small that you don’t really get paid anything worth the hassle or risk.

GameStop is a Dangerous Mirage

We hate to say it, but GameStop is a dangerous mirage. It might look sexy now, but it’s only because it’s a story stock.

Don’t think twice about passing on something like this in the future if you’re really in it for the long-haul and want to earn some serious cash.

What should you do instead? From our expert investor: Invest in good businesses that are growing revenue and profit in the double digits, especially when they decline for non-fundamental reasons. Subscribe to receive updates on this series.

Look out for our next article on Should You Invest During a Short Squeeze?