Lesson From GameStop Stock Pump and Dump Scheme

Once upon a time, there was a Zombie corporation named Game Stop ($GME). For the last few years, it has been circling the bankruptcy drain. Similar to Blockbuster, its business model, renting and trading video games and equipment, is going the way of digital streaming. GME’s brick and mortar operations held a competitive advantage versus most competitors. Unfortunately, in today’s digital streaming world, they are minnows, prone to attack by the likes of Amazon.

We tell the story of GME because it’s fascinating. More importantly, however, it holds an important lesson about the Speculation in Trading

During the dot-com bubble of the late 1990s, Yahoo message boards were the outlet of choice to share “can’t lose” ideas. Today the setting has shifted to reddit message boards, with “r/wallstreetbets” being the most popular.

GameStop is no where near worth what it was trading at but it’s a perfect example of the greater fools theory where it’s possible to make money on something if it’s overvalued so long as there’s someone willing to pay a higher price.

GameStop Wraps Up Worst Week Ever, Leaving $18 Billion Hole.GameStop’s market value slipped to $4.4 billion, a far cry from the $33.7 billion value it hit on on Jan. 28 when it briefly became the largest company in the Russell 2000 Index.

Little History on GameStop

Gamestop is a retailer that sells video games in physical form. Which has been a problem, because people are increasingly buying games online. Gamestop, listed as ticker GME in the US, has recently lost $275 million  on revenues of $5 billion or so. GME is a company with a dim future. Like other companies that did not adapt to technology, GME will likely follow them into bankruptcy or become an inconsequential player.

GME’s stock opened in 2019 at $15 a share, and by January 2020, it was only $6. The writing on the wall was becoming fate. COVID-related economic shutdowns made matters worse, and the stock flirted with $3 in March 2020.

GameStop has been losing money and expected to continue to do so with revenues on the decline. The only thing thing that matters in the short run is supply and demand, and demand for shares has been skyrocketing.

Some hedge funds likely value GME near zero. Surely a few of them were accumulating shorts in large quantities, hoping to repurchase them when GME was a penny stock. It appeared to be easy money, Like Option Sellers selling Rs1-2 Options on Expiry day, Even with a low price, shorting GME offered good returns. Accordingly, the shorts stuck with the trade.

By late August 2020, the stock doubled to trade near $6 a share. Despite doubling, the trend of the last few years’ was firmly intact. More importantly, for the short investors, the fundamental story hadn’t changed. It’s likely some thought the price gains were a gift and added to their shorts.

As the calendar progressed, the stock moved higher. GME closed September at $10, October at $12, November at $18, and for the year at $20. Hedge funds that liked shorting it in the single digits must have loved shorting it at $20.

These new investors likely have little idea of what GME’s balance sheet or income statement looks like. Nor do they care. They saw an opportunity to join forces and make a lot of money. They saw a way to stick it to Wall Street, and they did.

As the stock price recovered in the fourth quarter, short interest rose. In fact, there were more shares shorted at the end of December than shares outstanding.  Retail traders could sense the squeeze, while hedge funds thought they were adding shorts with massive potential.

The rouge retail traders, including some large investors like Elon Musk, David Portnoy, and Chamath Palihapitiya, understood they could buy and push GME ever higher. Their logic was that the shorts would get squeezed and have to buy back their shares to limit losses. As this occurs, the short-sellers buying back shares help their cause.

And to top it all off, Elon Musk expressed his support, sending the stock to another level in after hours trading…

The result: at a market cap of over $15 billion, GameStop is now more than 12x higher than the start of the year.

Melvin Capital  had a large short position has already needed a bailout

Conclusion

“It’s the same phenomenon as the Dutch going crazy in the 1600s buying tulip bulbs. It’s happened time and time again. These speculative manias are likely to be a fact of life forever…In some sense like a game of musical chairs, there’s somebody who’s going to be left standing.”

This is going to be a painful lesson for newbie investors. The slick new no-fee brokerage platforms like Robinhood might make trading in shares and options appear to be another form of gaming but some of the Reddit-encouraged horde will have lost their life savings.

1. Accept responsibility: You made the loss; be sure to own it. Don’t brush it aside, hide from it, or blame the “smart money” for your loss. When you take ownership, you control your trading — and that’s exactly where you want to be.

2. Stop trading: Take a break to figure out what went wrong. Assess what happened by reviewing events carefully. Think about where you fell short. For example, did you take too much risk? Was the trade well-planned? Were you mentally sharp, or did you hold a losing trade hoping to avoid a loss?

3. Have a plan: Make a detailed action plan for future trades. The ingredients of your plan should include things you will do differently (e.g., setting and honoring a stop) and also what you will no longer do (e.g., holding a loser, hoping it will return to break-even).

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