One West Virginia University financial expert believes the recent stock surges of GameStop and other companies undermine public confidence in the market and could ultimately harm the economy.
A coordinated effort by individual traders on social media platforms has manipulated prices for GameStop, AMC Entertainment, Blackberry and others, said Alexander Kurov, Fred T. Tattersall Research Chair and Professor of Finance in the John Chambers College of Business and Economics.
GameStop stock shot up more than 1,700% since early January and, now, some trading platforms are restricting trades on the video game retailer. Kurov explained what’s happening.
Can you explain what’s happening and how stocks are being influenced?
“We are seeing coordinated efforts by individual traders to push up stock prices of these companies (GameStop, AMC Entertainment, Blackberry, etc.). These efforts do not appear to have a single leader or mastermind. But there is clearly coordination going on, with individual traders encouraging each other to buy the stocks or call options on the stocks of these companies. For example, a user on Discord, a social media platform, posted earlier this week, ‘Guys, we need to pump $GME. Everyone buy 1,000 shares in exactly 60 seconds.’
“It appears that these traders have targeted stocks that are heavily shorted. In a short sale, a trader who expects the price of a stock to decline borrows shares of the stock and sells them. The goal of the short seller is to repurchase the stock later at a lower price and make a profit. Short selling can be very risky because if the stock price goes up instead of declining, the short seller can suffer very large losses. Therefore, when the price of a shorted stock jumps, short sellers are often forced to cover their positions by buying the stock. Aggressive buying by short sellers covering their positions tends to drive the price of the stock higher. This creates a self-reinforcing feedback loop, as more and more short sellers bail out and push the stock price still higher.
“When someone intentionally pushes the stock price up to make short sellers cover their positions, it is called a ‘short squeeze.’ Now the traders that manipulated the stock price by pushing it higher can sell and make a profit. This reverses the momentum and the price of the stock falls. So a short squeeze creates a short-lived price ‘bubble’ that quickly inflates and then pops. Short sellers (mostly hedge funds that had large short positions on these stocks) lost billions of dollars in the last few days.
“Stock price fluctuations during the short squeeze can be dramatic. For example, the stock price of GameStop increased from about $20 to $347 in the last two weeks. The stock price of AMC Entertainment increased from about $2 to almost $20 in the same timeframe.
“In addition to buying these stocks, individual traders also buy call options on them. A call option gives the holder the right to buy the underlying stock for a fixed price on or before a specified date. For example, a call option on GameStop with an ‘exercise’ price of $20 gives the holder the right to buy the stock for $20 per share even if it’s trading for $340. Market makers who sell these call options have the obligation to sell the stock for the exercise price, even if it is trading at a much higher price. So selling call options is risky. To get rid of this risk, market makers have to buy the stock. If the stock is not very liquid (and the stocks involved in the current events are not very liquid), this buying by market makers tends to drive the stock price higher, increasing pain of the short sellers and making the price swings larger.”
Should investors get in on the action?
“This is a very risky game and I would not recommend playing it. The GameStop story is often framed as the little guys sticking it to big institutional traders, and there may be some truth to it. But these bubbles also have some characteristics of Ponzi schemes. Many small traders who ‘get on the train’ late will be left holding the bag when these bubbles collapse.”
Are there ethical issues surrounding this?
“This is clearly price manipulation, and the issues involved are not only ethical but also legal. Manipulation is very hard to prove or prosecute, however.
“Coordinated price manipulation by retail traders on this scale seems to be new. Is it here to stay? This depends on whether regulators (and self-regulatory organizations of the financial industry) catch up. What is going on with GameStop, etc. makes the stock market look like a casino (or a video game) where prices are completely disconnected from fundamental values. I think this undermines public confidence in financial markets.
“It also makes short selling (which is already risky) even riskier. Short sellers have a bad rap, but they play a useful role in the market, helping to keep prices linked to fundamentals. When stock prices lose this link to the underlying reality, they don’t provide price signals that are really important for the economy. Bubbles and crashes are not good for Main Street. For example, bursting of the real estate bubble in 2008 caused the Great Recession.” - Alexander Kurov, Fred T. Tattersall Research Chair and Professor of Finance, John Chambers College of Business and Economics
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