A BRIEF HISTORY OF STONKS

It is very likely that you managed to hear this week about the GameStop stock kerfuffle. I mean, it went to the level of Saturday Night Live making jokes about it; that is about as mainstream as it gets. But you may not understand exactly what happened, and what it says more broadly about the financial system most of us live in. So let's do this.

IMPORTANT: not to spoil the rest of the article, but the important takeaway here is: if you've invested in GameStop, the safest thing to do (not the most profitable, but the safest thing) is to sell that stock right now before the whales offload it and you're out a lot of money. If you haven't invested in GameStop, definitely don't do it now.

Before anything else, you first need to understand the basic concept of shorting stock. Normally, when you want to make money off stocks, you buy low and sell high - you buy That Stock at five dollars and then when it goes up in value you sell it at ten dollars, you've made five dollars. Short selling is the act of doing this in the reverse order - you sell the stock before you ever purchase it at ten dollars, and then when it loses value you buy the stock at five dollars. The answer to the question of "how do you sell something you don't already own" is quite simple: you borrow it from someone who does own it, and then you have to give it back to them when you buy it back, and usually there are conditions on how long they have to wait before you buy it back and further conditions where you have to give them money if they don't get their stock back on time.

The act of shorting a stock in and of itself tends to reduce stock value (because in stock world, selling stocks makes them go down in value, and shorting a stock begins with the act of selling a stock), so in our modern financial system, stock traders are looking, all the time, for short targets - IE, stocks of companies which are vulnerable at present. GameStop is a great example of a short target because it's a shitty retail store nobody liked in the first place whose locations are mostly in malls (which are themselves slowly dying out) and also it's a pandemic and a lot of them are required to be closed. It is not a company whose fortunes are likely to get better in the immediate or even medium future, which makes it much more attractive to short because there is less risk of its stock value increasing - which can cost the person shorting the stock money because if the stock increases in value, you have to buy it back for more than you sold it, and so you lose money.

(If, at this point, you are wondering "wait, what is the value of letting people effectively try to drive down the value of companies because they want to gamble on whether or not those companies die," good work, you're in the advanced class! The answer is "I have no idea.")

A few hedge funds, and in particular one hedge fund called Melvin Capital, decided to short GameStop because it was an appealing target to short, and they went all out, actually managing to short more shares of the stock than actually existed - and yes, you can do that, basically by borrowing shares, selling them, and then borrowing them again from the people you just sold them to. So now Melvin Capital and its friends had shorted about 140 percent of all the GameStop stock that exists, which was a risky proposition - but if GameStop's value kept dropping then it was basically free money, and since they were shorting it so much its value kept dropping, which meant they were in fact poised to make lots of free money. This is where Wall Street Bets (or r/wallstreetbets, or just WSB) enters.

FIRST INTERLUDE: WSB has been portrayed over the past week as some eclectic community of millennial day traders, and although it is sort of that, it also really isn't that because WSB is also an online community frequented by low-level finance bros who like to post what they call "loss porn," which means screencaps of money they have lost gambling on various stocks. These are not Joe Averages sitting in their home offices tinkering with small portfolios; compared to your average day trader, a lot of the WSB elite are whales (at least relatively speaking).

Anyhow, WSB looked at what Melvin and the other funds were doing, and said "when this stock gets cheap enough, there is going to be opportunity to make some money and also fuck over those hedge funds." (They were predicting this back in October, for the record.) Basically, what they realized was that if shorting GameStop's stock drove GameStop shares down to really low prices, it would become rather easy to buy tons of cheap GameStop stock - and they did.

See, here is the thing about shorting shares - when it comes time to pay back the guy you borrowed the share from, by giving him back his share, you have to have a share that you can give back to him. WSB - and others - simply bought up all of the super-cheap GameStop stock and then refused to sell it back to the hedge funds, because they knew that the hedge funds would start offering more and more money to buy those shares back because the alternative was to pay the guys they borrowed the shares from in the first place more and more money as interim compensation for the shares they hadn't yet received back. All of this happened, and as the first few traders sold their shares at inflated value, GameStop's share price started rising, which was the short sellers' collective nightmare because now they were poised to lose a metric shitload of money. The term for this is a "short squeeze."

SECOND INTERLUDE: It's important to understand another thing about this entire affair, which is that although WSB has been portrayed as the community that made all of this happen, they weren't. There's plenty of evidence that some large institutional traders were buying up GameStop stock for the exact same reason that WSB members were buying it: because experienced traders know what a potential short squeeze looks like.

The fascinating thing here is that at this point - when the price of GameStop had risen from about four bucks a share to about twenty - Melvin and the other shorters probably could have escaped at this moment with their shirts intact simply by making decently large cash offers to escape their position. They mostly did not do this: instead, Melvin in particular increased their short position by shorting more shares of GameStop in an attempt to drive the price back down. This, it turns out, was a bad idea, because this was about the time that the GameStop stock affair went viral and suddenly every day trader around was trying to buy GameStop stock to make a quick buck, and the price skyrocketed to just over four hundred dollars per share, which is three times as much as Apple is worth.

This more or less gets us to today. There has of course been a lot of follow-up news on the GameStop story - Melvin is trying to get people talking about a government bailout for them (seems unlikely), various stock-purchasing apps like Robinhood have tried to interfere with people buying GameStop, and WSB has glommed onto this mostly-fictional idea of themselves as proletarian avengers by encouraging people to buy GameStop and hold it to punish the hedge funds, which not coincidentally has the side effect of keeping the high prices stable so the whales who were WSB's elite can continue to profit.

At this point day traders are hungrily looking for "the next GameStop" - another low-price stock that traders have shorted heavily that they can squeeze - but the problem is that overshorting as in the GameStop example is extremely rare. Nonetheless, a whole ton of people have bought stock in Nokia, BlackBerry, AMC and Tootsie Roll (yes, seriously) because traders have shorted those stocks a fair amount in order to try and squeeze the shorters, and they have seen some incremental value gains, albeit nothing on the scale of GameStop (which was really something of a black swan event). These aren't much more than classic pump-and-dump schemes, and a lot of people are going to lose a lot of money really soon, because most day traders can't compete with professional traders - who buy and sell faster, have better predictive software and have more money to throw around - and the pros are already smelling newbie investor blood.

If all of this has left you wondering "but isn't the stock market supposed to reflect the actual value of companies listed on it," well, welcome to the real world, where Uber - a company that has literally never made a single dollar in profit and has a business model that makes absolutely no sense - has a market cap of just under ninety billion dollars. Or consider Tesla, which has a market cap of over $750 billion, which is nineteen times the market cap of Ford, despite the fact that Ford made about five times as much profit last year and also makes more electric cars than Tesla does and also Tesla's only actual profit stream is selling carbon credits to other carmakers because they lose money selling the cars and always have done. Do you really think Tesla is worth nineteen times as much as Ford? Of course not. But the stock market has decided it is, so... yeah.

See you in seven.