Professor Erkis, GameStop has been all over the news lately as its price has been up a huge amount. Why is this happening? Is it too late to buy the stock? – multiple students
Yes, we live in interesting times. At the close on Friday, Jan. 29, the price of GameStop stock was around $330 per share, down from a high of $483 per share.
This column is not advocating buying or selling any stock or stock options. For full disclosure, at the time of this writing, I own a financial instrument (a put option) that will profit if the price of GameStop stock decreases below a certain level. Readers should consult a financial advisor before making any investment decision and should not rely on anything in this column as financial advice.
As for the explanation, here it goes. Stock prices are determined in the short term by supply and demand. This is basic economics. More demand leads to higher prices and less demand leads to lower prices. Many people believe that over the long term, a stock’s price should reflect the company’s long-term profit potential or the company’s intrinsic value.
GameStop has been closing stores and having financial issues due to the pandemic. The stock price was about $13 per share in November 2020 and rose to $18.84 at the end of 2020. The stock price jumped to $39 in early January when the company added new board members. Often, the addition of new board members leads to optimism that a company can turn things around financially. The optimism sometimes is valid and sometimes is not.
During this time frame, some large investors, called hedge funds, believed the stock’s price was too high and would soon fall. These hedge funds decided to “short” the stock by borrowing GameStop shares, selling them immediately and then expecting to later repurchase the stock at a lower price to end the loan. Hedge funds often short stocks on a huge scale and can profit handsomely when it works.
In this case, things did not work out as the hedge funds expected. Individual investors, using social media, said they were going to buy GameStop stock and hold onto it no matter what the price does (HODL) and suggested others do the same. This additional demand led to further stock price rises. As the price started to increase, more and more people saw the price going up, thought it would continue and also bought the stock. This led to rocket-like increases in the price of GameStop’s shares.
The hedge funds who shorted the stock had losses and many attempted to buy the stock back to end the loan. Unfortunately for them, they needed to quickly buy a lot of stock before they experienced even larger losses. This rush to buy, coming at the same time, made it difficult to find people willing to sell (this is called a “short squeeze”), leading to higher and higher prices.
Like every buying mania, those who buy early can make a lot of money. For example, 50 shares of GameStop purchased at $20 per share at a cost of $1,000 would now be worth $16,500 at $330 per share. Those buying at higher prices often lose money as the stock price over time should find the level close to the company’s intrinsic value (i.e., what the company is really worth over the long run). As the old saying goes, “What goes up, must [eventually] come down.”
