Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Rarely does the niche world of small investor share trading break out and gain the attention of the world’s media, but the saga of GameStop has changed all that.

The headlines today are filled with the huge (paper) fortunes that some investors have made buying shares in the American computer game retail chain. The plot is thickened by the fact their gains have seemingly come at the expense of mega-wealthy Wall Street hedge funds, some of which have been pushed into financial difficulty. It is a story of the little guy, for once, holding the whip-hand in the world of high finance.

To understand what has happened, what changes could follow and what, if anything, should you do about it, some context will help.

For years, amateur share traders have gathered online to discuss the stocks they buy and sell. One place they congregate is the community forums of Reddit. Over the past few weeks, the discussion in one such forum has turned to GameStop. The company has been down on its luck because its traditional business model - selling physical format computer games in bricks-and-mortar stores - has been in decline for years, along with GameStop’s share price. Of most interest to the forum members, however, was the large proportion of ‘short’ positions currently held in the stock.
‘Short selling’ is a sequence of financial trades which allows investors to effectively bet on a stock going down. Normally, investing means buying an asset at one price and hoping that it will rise in value. When the asset is sold you can make money.

When investors short a stock, however, they first borrow it from someone else, typically a financial institution of some kind. They borrow the stock for a specified period of time, after which they will return it back to the lender, who is paid for their trouble into the bargain. Once in possession of the borrowed stock, the short-seller sells it at the current market price. If the stock then falls in value, as they hope it will, they can buy it back more cheaply to repay the lender and pocket the difference in price.

It’s a complex business that tends to be the preserve of professional investors, like hedge funds, and the risks can be high. The potential losses from traditional buy-and-hold investing are limited because an asset price can only fall to zero but no further. In a short trade losses mount as the asset price rises - and there is no technical limit on how high it can go.

Once Reddit forum members spotted that short-sellers had taken big positions in GameStop, they began to encourage each other to buy the stock. Their reasoning was that the demand from small investors like them would push the price higher and put pressure on the short-sellers - a ‘short squeeze’. They knew that short-sellers would have to buy the stock back at some stage to return it to their stock lender and close their trades, and when they did it would only add to demand for the stock and push the price even higher.

That’s what’s happened in the past few days. The GameStop share price rose from around $39 on January 20 to $348 yesterday. Some notable hedge funds have closed their positions at huge losses, but there remains a large proportion of short trades open meaning there may be even further to go.

Right now, the small investors are claiming victory but we only have half the story. At some stage, the upward momentum will expire and many people will be left holding very highly-priced shares in a company that cannot justify that valuation. There will be a stampede for the exit and the price is liable to fall just as sharply as it rose.

If there is an impact on the wider market from the episode, it may be to discourage hedge funds from some shorting activity. GameStop was the most dramatic case but several other stocks have also experienced a short squeeze from small investors and Reddit forums will be filled with other potential targets. There may also be some additional some short-term volatility in markets as large institutional investors close positions.

For most investors, however, the GameStop rollercoaster is a sideshow. Traders like those who have bid up GameStop are interested in short-term momentum of price movements. They are hoping to make big money in a short period of time. But if you invest your money to help your long-term savings or to fund retirement your aim is to make gains over the long-term. Your investment decisions are based on the fundamental strengths of a company, and its valuation when compared to those fundamentals. That’s worth remembering as the GameStop saga reaches its finale in the coming days.

Important information: Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. Overseas investments will be affected by movements in currency exchange rates. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.    

Topics covered:

Active investing; Shares; Volatility; North America; Risk and reward

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