Decoding the GameStop Scene — 1

If you haven’t been living under a rock (or without wi-fi in Delhi or Haryana) then you probably must have come across a few references with respect to a few amateur investors coming together on Reddit and taking on(and for now, winning against) the professional investors of Wall Street by locking horns over the valuation of a company named GameStop. With investment jargon you may not be familiar with, like Shorting and Call Option being thrown around like confetti, it can be pretty confusing to follow what is exactly going on in the market right now.

So wanna know about how numerous strong-willed Davids took down the Goliaths of the wall street, shook down a section of the market and (momentarily) saved a company from going down under? We have the perfect article series for you!

Let’s begin with going over a few basic terms used in the investment world as they play a major role in this saga.

SHORTING

Shorting a security (think shares) is a strategy in which an investor bets for the downfall, in other words against that particular security.

So how does it work? Typically when you buy a share (let’s say for $10), the particular share now belongs to you. You then sell it at a later time and accordingly make a profit or a loss based on the price you sell it at. Theoretically speaking, at max you can lose $10 if the share price goes nil whereas, on the other hand, you can hit the jackpot as there is absolutely no limit on how high the price could go.

Shorting happens to be the exact opposite of the above in which you sell the share first and buy it later. But how can you sell something you don’t own in the first place? You borrow. You borrow it from a financial institution via your broker or bank with the obvious requirement to return them at a later stage with an interest payment. Note here, that in this case if you sell the share first, say again at $10, there is a finite amount of money you can gain in the process ($10 if the price goes nil) but conversely, you are also subject to losing a gigantic amount of money if the share price were to rally up.

Moreover, one does not have the luxury to hold a short position for as long as you please since here there is a liability to buy back the shares and return them to the lender.

SHORT SQUEEZE

When a share which is heavily shorted ends up rallying, rather than go down. Then the surge of buyers trying to frantically buy back the shorted stocks ends up putting upward pressure on the stock’s valuation.

The GameStop scenario is a case study in what a Short Squeeze is.

CALL OPTION

A call option is a financial contract where the option buyer gets the right, but not the obligation to buy the underlying financial instrument at a specified price within a specific period of time.

Let’s simplify the above definition. You believe that the value of a particular share which currently goes in the market for $20 would increase in the future to a much greater price. Now, in place of buying shares to strike a profit, you go a different route. You buy a contract (for say $1). This contract gives you the right to buy shares for a specified amount, the strike price(say $25) any time in the future no matter what it’s market price is at that moment. Also to note is that this contract is only valid for a particular duration of time (say 1 month) after which the contract will expire and you can choose to go ahead or not with the buying of that share. If everything goes according to plan and the share during the 1-month duration hits, say $35, then you have the option to exercise the contract at that moment and buy the shares at the specified $25 and immediately sell the shares in the market for the current market price of $35. This process fetches you a profit of $35 — $25 — $1(the price of the contract) = $9.

On the other hand if during the entire month the share price rather than rallying up, goes the opposite way and the share tanks to say $5, you can simply choose to walk away from the deal and in the process, you just lose money equal the price of the contract ($1) rather than the entire price difference.

If the price of the share goes up, the price of these call options also starts increasing and vice versa.

For every buyer there needs to be a seller and being at opposite ends, their conditions to make profits are also opposite. Because of how risky a deal these options could turn out to be for the seller, the sellers often buy shares in advance so that in case the price of the share rises and he is bound to lose money from the call contract, he has his losses covered as his owned shares will fetch him a profit.

Point to be noted:- Selling a Call Option, without having bought the shares, is a way of shorting against those shares.

These concepts would serve to be instrumental in the understanding of how events unfolded. Till then, stay tuned for our next piece on the company in the midst of the controversy: GameStop.