Explainer: How retail traders squeezed Wall Street for bets against GameStop

LONDON (Reuters) – A surge of retail stock trading over the last year lit the fuse that sent shares of GameStop Corp rocketing higher without a clear business reason, market watchers say, squeezing hedge funds that had bet against the video game retailer and other companies that were out of favor on Wall Street.

FILE PHOTO: Outside a GameStop store people line up to purchase a Sony PS5 gaming console in the Manhattan borough of New York City, New York, U.S., November 12, 2020. REUTERS/Carlo Allegri

What is going on? Here are some answers:

BEHIND THE SURGE IN INTEREST OF RETAIL INVESTORS:

More individuals have invested in stocks during the COVID-19 pandemic, and experts cite a number of reasons. Lockdowns boosted savings, policy stimulus put cash into people’s pockets, and extremely low interest rates drove investors to the stock market. Also, a proliferation of trading apps allowed anyone with a smartphone to buy or sell stocks for free.

Retail investors’ participation in U.S. equity order flows increased to nearly 20% in 2020 from 15% in 2019, while orders from long-only funds fell to 6.4% last year from 9.7% in 2019, data from Swiss bank UBS showed.

Data this year suggests further growth. Online broker eToro said it registered more than 380,000 new users in the first 11 days of 2021, adding to the 5 million who used it last year, for example.

Retail investors are also buying stock options, the right to buy or sell shares at set prices without putting cash upfront. That takes their dollars much farther and can turbocharge share price movements.

WHAT HAS BEEN THE IMPACT OF THIS SURGE IN RETAIL TRADING?

Big U.S. technology companies were among the beneficiaries last year. Facebook, Amazon, Apple, Netflix and Google-owner Alphabet saw record inflows as their businesses benefited from lockdowns and their stocks soared.

With unprecedented stimulus and easy money policies from central banks, investors then shifted to smaller stocks, especially ones that got beaten down during the pandemic.

Market capitalization of world stocks surged to a record $88 trillion, a whopping $33 trillion jump from the March bottom. In the last few days, GameStop’s shares have jumped 1600%, with big gains also for shares of AMC Entertainment Holdings Inc, Blackberry Ltd, Nokia Oyj and others.

WHAT’S HAPPENING ON REDDIT AND SOCIAL MEDIA?

Online discussions about stocks on social media platforms such as Reddit, Twitter and Facebook are seen by many traders and analysts as fueling massive share price moves that cannot be explained by fundamental news or traditional valuation metrics. Retail investors have long discussed stocks on social media, but during the pandemic these forums appear to be gaining more influence. Investors pointed to discussion threads such as “WallStreetBets” on Reddit for driving the surge in GameStop.

Professional investors are paying attention. Dennis Dick, a stock trader in Las Vegas said he reads the site Seeking Alpha before work and keeps up to the minute by watching Twitter, but last weekend he also joined a group on Reddit “because I need to know what’s going on.”

HOW HAS THIS AFFECTED HEDGE FUNDS AND PROFESSIONAL TRADERS?

Massive share price swings for no apparent reason have caught Wall Street off guard. Short sellers, or investors who bet the price of a stock would fall, are getting crushed. Melvin Capital, a well-established hedge fund, took massive losses on its bets that GameStop share would fall.

Traders scrambling to cover these short positions and prevent further losses had to pay inflated prices, which added more fuel to the rally. Several traders told Reuters that this phenomenon — the classic short-squeeze — drew in still more retail investors hoping to ride the wave.

WHAT ARE THE RISKS?

With global stock markets surging since March despite the pandemic’s devastation of the real economy, investors and analysts are warning about asset bubbles. If markets turn, overvalued stocks will fall with them. Many trading platforms also offer loans to investors to buy shares and magnify their returns. In a falling market, that could wipe out people caught on the wrong side of the trade.

Reporting by Thyagaraju Adinarayan, additional reporting by Saikat Chatterjee; Editing by David Gregorio