GameStop and Melvin Capital

What happened in GameStop shares in early 2021?

In early January 2021, GameStop, a US video game retailer was trading at $17 per share. A month later it was trading at $300 and briefly touched $500. This price action is known as a ‘short squeeze’ and happens when market participants become aware that there is a considerable number of short positions in a particular security and therefore if they buy it aggressively they might be able to force the short positions to ‘throw in the towel’ and buy back their shorts. This buying would push the price even higher allowing the original buyers to exit at a profit.

Why did the share price behave as it did?

The short squeeze in GameStop shares happened for various reasons. Crucially, the market was aware that certain hedge funds had a large short position, due to regulatory filings required of such funds. The reason for the large number of short positions was that a traditional retailer such as GameStop was seen to be at risk, firstly, from the increasing move towards digital distribution and, secondly, the impact of Covid in keeping people out of shops. An additional factor was the bringing together of buyers on the social media website Reddit. Various investors showed an interest in buying the stock, and even Elon Musk highlighted the forum’s recommendations on his Twitter feed. A further issue was the sheer size of the short base. Many funds consider it dangerous to short a stock where the total amount of shorts exceeds 10% of the total stock, yet GameStop had over 50% in shorts at various times over the preceding year. This meant that a rally in the price had the potential to lead to a lot of forced buying.

What was the impact of the events in GameStop shares?

The move higher in the share price did indeed force many short positions to throw in the towel. Melvin Capital lost half of its $13bn assets under management and needed a cash injection of $2bn from Citadel and another $750m from Point 72 Asset Management. Another issue was that Robinhood was forced to stop clients trading in GameStop as the high volatility increased the amount of margin that Robinhood needed to post on exchanges where it was executing client purchases. Selling order flow, as Robinhood had been doing to Citadel, came under increased scrutiny. Robinhood charged zero commission but made money by passing their orders to the hedge fund Citadel. Citadel values this flow for the information it gives them. As of April 2021, the final chapter in the Gamestop saga is still being written, and it remains to be seen what other legal or regulatory ramifications may unfold for the market and the various stakeholders involved.