The GameStop spike: Associate Professor Adam Aiken offers insight into the stock’s viral rise and fall

Aiken, an associate professor of finance, explains many of the forces at work in the rapid spike in the video game retailer's stock price, and what the long-term implications may be.

The past few weeks have seen millions made and lost as Wall Street traders and hedge funds rode the rise and fall of stock in GameStop, the video game retailer some had written off and others believed was on the rise. During the course of just a few weeks, the GameStop stock price spiked from about $20 per share to close to $500 amid rabid investment fueled in part by activity on a discussion board on Reddit.

headshot of Adam Aiken
Adam Aiken, associate professor of finance

The story of GameStop’s unlikely rise brings together multiple forces and storylines. The rise demonstrated the power of individual traders and the ability for online discussions to translate into significant movements in stock prices. It thrust into the spotlight the benefits but also limits of financial trading apps such as Robinhood that have made trading more accessible to the broader public.

We turned to Associate Professor of Finance Adam Aiken to discuss the forces at work in GameStop being thrust into the Wall Street spotlight and to look ahead at how this episode may resonate in the future.

Talk about the various elements that led to GameStop’s stock price to rise so quickly and so high.

There are several elements, some old and some new. First, manias and bubbles have been around since the very first markets. Nothing new there – it’s who we are. And using the internet to share trade ideas has been going on since AOL chat rooms, though we didn’t have Emojis back then. Finally, you actually could tell a story about why GameStop’s stock might have been undervalued back when it was $20 or $30 a share. These posts had been on Reddit and its WallStreetBets subReddit for a while and some professional investors agreed.

The new element is really the ease of trading and the interplay between short sellers and the use of options. This is why the stock didn’t stop at $40 a share. Back in the tech boom of the late 1990s, trading was still relatively expensive. Now, Robinhood and most other platforms offer some kind of zero-commission trading. This makes it very easy to press that button on your phone and participate in the buying.

The short selling and the options element are perhaps what made this frenzy particularly interesting. First, while some professional investors thought GameStop was undervalued, others thought that they were another doomed retail chain. These latter investors were short the stock. This means that they will make money if the stock goes down. However, if you are short a stock and the stock goes up, you lose. And, since there’s no limit on how high a stock can go, you can lose a lot. When you lose a lot, you are forced to close your position at a loss.

That price might not end up being right, but it is tough to tell whether any stock is overvalued or undervalued at any point in time. Trading is hard.

Second, many of the retail investors on WallStreetBets were using call options. A call option is the right, but not the obligation, to buy a stock at a particular price. You pay for this right – this is called the premium. Long story short, if you buy a call option, you can make money if the stock goes up. The options dealer who sold it to you would lose money.

The dealer doesn’t want to lose that money, so they will hedge this position on their end by buying the stock, offsetting the losses on the call that they sold. If the stock keeps going up, then they will need to buy more stock to hedge the position, which can increase the price, and so on. This feedback loop is sometimes called a “gamma squeeze”.

The hedge funds that are short the stock see this price increase and feel the pain. They are forced to buy the stock to close out their short position, which also increases the price of the stock, at least temporarily. This is called a “short squeeze”.

So, you had several temporary and unusual dynamics happening all at once that drove the stock price up to values that had nothing to do with the underlying stock price.

Finally, underlying all of this is what I guess I’ll call the sociology of Reddit and WallStreetBets. There was definitely a feeling of “getting back at Wall Street” or that it was “my turn to get rich”. Why did this happen now and why did these feelings seem to coordinate around GameStop? There seemed to be some anger at short sellers and GameStop was a heavily shorted stock. But, short sellers are actually pretty minor players in financial markets and are often celebrated for finding corporate fraud and bad behavior. For example, short sellers were pointing at Enron before they collapsed. I can think of bigger villains in finance.

Stock prices are theoretically tied to core business elements such as revenues and profits, but that wasn’t the case here, was it?

There was perhaps some underlying optimism about the firm that played a role at some point, but, no, there was no way to justify a price of nearly $500 a share without invoking the “greater fool” theory – that someone else would be willing to buy the shares from you.

Is there a similar historical example of a stock price being manipulated in this way?

Weird things do happen. The example that comes to mind is Volkswagon back in 2008. Over a couple of days, their shares quadrupled due to a short squeeze related to Porcshe announcing a larger stake in the firm. They were briefly the largest company in the world, by market value at least. Things got back to normal quickly, though.

I’ll just add that the fact we remember these events suggests that, most of the time, the stock price that you see is the collective “best guess” for the value of the firm. That price might not end up being right, but it is tough to tell whether any stock is overvalued or undervalued at any point in time. Trading is hard.

This is being billed as individual investors taking on hedge funds, which had bet against a rise in GameStop’s stock price. Is it clear who the winners and losers are?

The winners include anyone making money on trading volume, like market makers. These are the firms that get paid to match up buyers and sellers and include Citadel, the firm that purchases Robinhood trades in order to complete them. I’m sure that some hedge funds were winners too, as they navigated the volatility and traded both with and against the WallStreetBets crowd.

Melvin Capital, the hedge fund that was short GameStop, seems to have lost over 50 percent in January. They lost, but I’m sure the individual managers will be fine. Hedge funds are professional investors, but even professional investors make trades with poor risk controls and “blow up.” They often even start up a new fund after they blow up! The meltdown of the hedge fund Long-Term Capital Management back in the 1990s was a much bigger market event that required intervention organized by the New York Federal Reserve. Still, many of the participants went on the create new funds.

And I guess the Mets were losers, since Steven Cohen, their owner, lost some money in all of this. But, as a Mets fan, this is typical and expected.

Hedge funds are professional investors, but even professional investors make trades with poor risk controls and “blow up.”

The biggest losers are, of course, the individual investors who got caught up in the trading and lost money that they couldn’t afford to lose. Sure, some retail investors made money during this. Some of the WallStreetBets posters understand a lot of finance and are likely professionals. And some people got lucky and managed to sell near the top. But, many, many people involved in the trading lost a lot of money essentially playing musical chairs and ending up without a seat.

Could we see another episode like this, or do you expect there to be some regulatory action in the future that would prevent another spike like we saw with GameStop?

Strange things happen in markets, so I’m sure there will be another short burst of weird prices somewhere. We had VW. More recently, there were the “flash crashes” where the entire market dropped for half an hour. Markets are institutions, systems, and software designed by people and sometimes they can do unexpected things.

I’m not sure that regulators, like the SEC, will do much about single stocks moving around like this. There might be discussions about the wisdom of making margin accounts and options trading so easily available. In the end, I think that the system worked fairly well. Robinhood had to put up more cash to support all of these trades, which is exactly what was supposed to happen. Professional traders have tweaked their models to account for price behavior like this. Short sellers will be much more careful about how they structure their trades, in order to avoid being exposed.

Are there other long-term implications?

I hope that people learn from this and realize that there is really no reason to trade individual stocks, unless you just think it’s fun and can afford to lose the money. You don’t need a Robinhood account to save for retirement. We will always like the idea of quick money and fear missing out while others hit the lottery. But, we have to resist this impulse. The easiest way to “beat Wall Street” is to not play in the first place. Investing for most people is actually very simple, boring, and easy to automate, so you can go out into the world and do things that are much more interesting than watching squiggles on a screen.