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Created on 13.08.2021

Hedge fund series: What happened in the GameStop case and how are communities influencing stock prices?

Smaller investors who organize in online communities and use clever stock exchange interventions to bring mighty hedge funds to their knees? In the first part of our hedge fund series, we use the example of GameStop to explain how communities can influence stock prices and whether this action heralded a turning point for the financial markets.

Hedge funds, short selling, short squeezes – you will have to deal with quite a few technical terms if you want to understand the spectacular GameStop case that hit the media at the beginning of 2021.

We will therefore explain these terms in this miniseries. Below, we describe the role that hedge funds played in the GameStop case and what exactly happened. The miniseries is structured as follows:

What are hedge funds?

Hedgefunds  are usually managed by several managers. They analyze the share prices of companies or the prices of bonds and develop an investment strategy using various financial mathematical methods. If you want to invest in hedge funds, you usually have to be able to bring in a lot of capital. This is why it is primarily institutional investors such as banks, health insurance funds and pension funds that invest in hedge funds. Private investors must be very wealthy in order to invest in hedge funds. For smaller investors, this type of investment is usually not appropriate or not possible at all.

Hedge funds have a negative image with many people. This is because the way they operate is often described as non-transparent, high-risk and speculative. For example, hedge funds rely on falling share prices – on short-selling. In Part 2 and Part 3 of this series you will learn more about this process, which can generate profits despite falling share prices – known in the professional world as short selling and short squeezes.

For more on hedge funds, see the article “Hedge funds: achieve a return even in declining markets”.

A brief explanation of the GameStop case

The spectacular GameStop case, which played out at the beginning of 2021, probably attracted so much widespread media coverage due to the “David and Goliath” nature of the highly dramatic and cutting-edge case.

Hedge funds – Goliath in our analogy – are large, institutional and high net worth investors that seek to profit from falling prices. Various hedge funds were therefore speculating on falling stock prices for the US video game retailer GameStop Corp., since in the digital age it can be assumed that ever fewer physical video games will be bought. At the same time, multiple small investors came together on a forum of the Reddit website that was critical of wall street. They play the role of “David” in our story because they decided to drive up the price of GameStop stocks in order to damage the unpopular hedge fund. The rapidly growing movement soon resulted in a real run on GameStop stocks. The subsequent sharp rise in the value of the gaming company's stock meant that various large hedge funds that had been speculating on the opposite result were now facing huge losses.

Why did the GameStop story work?

The sharp rise in the stock price was triggered by a sub-forum of the Reddit online platform, where numerous private investors decided to buy the stocks in order to drive up the price. A few factors likely favoured the GameStop case:

  • the GameStop stock price was valued at around USD 20 in the first week of January, so it was (initially) quite affordable.
  • The entry fees for participation on stock market have fallen dramatically in recent years, and some stocks are easily accessible via various apps that make stock trading very cheap and intuitive.
  • Communication within communities is facilitated by social media, and well-known investors such as Elon Musk also fuelled the campaign with their tweets.

So in a matter of days, the stock price soared to over USD 300 – 15 times its original value.

What does the GameStop case mean for the financial markets?

There’s something fascinating about the idea of small investors teaming up to take out the big ones. But it’s questionable whether the David and Goliath analogy is truly appropriate.

It’s more likely that those involved can’t be so clearly defined as “large” and “small” investors. After all, some of the private investors were actually wealthy star investors. The GameStop stock price fell again after hitting its peak in early 2021, which means a heavy cost for many investors in the form of price losses. Likewise, not all hedge funds can be counted among the losers. On the contrary, various hedge funds were able to profit from the rise in stock prices. There’s probably no real winner in the speculation game – and for many, that’s all it was: a game.

Part 2 and Part 3 of this series describe the mechanisms that hedge funds use to benefit from falling stock prices, and why this case was an example of a “short squeeze”.

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