how Redditors played hedge funds for billions (and what might come next)

How does a small retail company that sells video games, worth less than US$400 million in the middle of 2020, become a US$10 billion company in less than six months? How does its share price climb from about US$20 on January 12 2021 to US$347 on January 27 – then fall back to US$193 the very next day?

The stunning price surge in GameStop shares, driven largely by hyped-up Reddit users with the aid of Elon Musk, has drawn the attention of the US government, led to calls for regulation from the head of the NASDAQ exchange, and even driven up the shares of an Australian mining company with a coincidentally similar sharemarket code.

How is this happening? The simple answer is it’s a power play, magnified by social media, between small retail investors who want some share prices to rise and larger hedge funds who have made big bets that those same prices will fall.

Revenge of the little fish

Melvin Capital is a hedge fund (worth US$12.5 billion until recently) with a “short position” on GameStop. A short position means Melvin was betting GameStop’s share price would fall (a reasonable bet, as the outlook for bricks-and-mortar video game stores is a bit like what happened to Blockbuster and other video rental outlets). This in itself is not at all unusual.

What made the past two weeks so unique was the heavy involvement of small individual investors in driving the action. Through platforms like Reddit (specifically the Wall Street Bets forum, which describes itself as “like 4Chan found a Bloomberg terminal”), these retail investors have worked to together to drive prices so high that hedge funds have had to abandon their short positions.

As a result, the short sellers have lost a lot of money and the retail investors (and anybody else with GameStop shares) have made huge profits. Normally on the stock market, the shark swallows the little fish. Now the little fish are eating the shark.

Read more: Explainer: what is short selling?

These individual investors started buying shares (and options to buy shares in the future) in GameStop, and other companies that had significant short positions. In fact, the 50 most shorted companies on the Russell 3000 index have gone up 33% this year.

This increase has become a surge in recent days. GameStop surged in value by 92% on January 26 (US time), leapt another 134% on January 27, and has traded more than 178 million shares. The average volume typically traded for GameStop is roughly 10 million shares per day. This is not normal.