GameStop's (GME) stock has exploded over the past few days. After trading below US$ 20 per share for most of December and the first few weeks of January, it's now trading at well over US$ 300 per share.   

And it's not just GameStop—it's also movie theater chain AMC Entertainment Holdings Inc (AMC) and clothing retailer Express (EXPR), among other stocks with (ahem) ailing prospects. Why are these stocks suddenly soaring? The coronavirus pandemic has wreaked havoc on movie theaters' profits as well as those of brick-and-mortar retailers. There wasn't much positive news from these companies or fundamental reasons for the increased demand for these stocks. 

So what's happening? It's a classic short squeeze, but this time, Reddit-style.

How and why do investors 'short' stocks?

When someone shorts a stock, they’re trying to sell something that they don’t actually own because they think they can make money later by buying it back at a lower price. Hedge funds do this a lot, but short-selling can be very complicated and risky for individual investors to attempt.

Here’s how it works: If you believe a stock’s value will increase over time, you want to buy it and hold it, which is known as taking a “long” position. But if you anticipate that a stock’s price will decrease, you could take a “short” position. To do this, you would borrow shares of the stock and sell them to another investor (even though you don’t own them). If you can sell the stock to that new investor for a higher price than what it will cost you to purchase the shares from the original owner to cover your borrowing, you will profit from short-selling.

If the stock’s price keeps rising, though, the short seller will have to repay the borrowed shares at a higher price than they sold the shares for. Because stock prices can (in theory) rise indefinitely, short-selling can lead to potentially

unlimited

losses. With a long position, by contrast, an investor’s potential gains are unlimited but the most you could lose is 100% of what you invested.

 

What’s a 'short squeeze'? 

A short squeeze can happen when there is enough increased demand for a stock that also has a lot of sellers making short sales (in other words, it has a high short interest ratio). That perfect storm of technical factors can push stock prices into the stratosphere--people are buying the shares, which forces the short sellers to buy the stock in an attempt to cut their losses. So, everyone is buying--the long buyers and the short sellers. And often a stock with a troubled future that attracts a short seller will not have a lot of trading volume, so small changes in demand can move the price quickly. 

What happened with GameStop?

GameStop had been struggling along with other retailers for years, even before the pandemic hit. Morningstar classifies the small-cap value stock as distressed, meaning it has serious operating problems and should be considered highly speculative. A look at its profitability metrics is sobering. 

There were a lot of institutional investors betting that GameStop would go the way of BlockBuster. Notably, as of Dec. 31, 2020, the short interest as a percentage of the float for GameStop was 260 per cent. So, there were many more people shorting the stock than there were shares available in the market. This is the perfect environment for some goofy trading to happen.   

Exhibit 1
  - source: Morningstar.com

Enter r/WallStreetBets, a Reddit forum for stock traders, with over 3.4 million users. People on the forum began talking up GameStop, for a variety of reasons, which led to massive coordinated buying. As one investor explained to CNBC, some of the investors in the forum are fundamentally driven investors who believed that GameStop could turn its fortunes around, particularly after e-commerce pet food company Chewy founder Ryan Cohen took an interest in the firm last August.

But many traders seem to be driven by a sort of anti-Wall Street backlash--perhaps believing that it's entertaining to see big hedge funds struggle at the hands of retail traders. Many traders purchased calls, which allow them to apply even more upward pressure on the short sellers per dollar spent. Whatever the reason, current fervor around GameStop has driven the price up massively over the past few days.

Exhibit 2  - source: Morningstar.com

This type of speculation can be thrilling—it creates an energy that feeds off itself. As a founder of the WallStreetBets Reddit forum explains in this Kiplinger's article, "WSB treats stock trading like a video game." And with one-click trading apps like RobinHood, stock trading can feel like a video game, too. (And I'll take it even further: GameStop literally sells video games.)

At the risk of sounding hopelessly sober: Investing shouldn't feel like a game, especially if you're committing large sums of money to it. There's a big difference between gambling and investing, and if you're only buying shares of a business because its stock price has skyrocketed, you're not investing. My advice—please don't fear that you're missing out on the GameStop trade, and be very skeptical of any other stock that seemingly everyone is piling into.