In the past few months, retail stock buying has been at the top of many news cycles. Shorts, market manipulation, clearinghouses, securities, derivatives, brokers, hedge funds — much of it is new to most people, even to some who are currently investing. So here is a breakdown of what happened, what everything means, the legality of it all, and what happens in the long run.
Let’s start with what the terms mean:
- Short — A short is essentially selling a stock with the promise to buy it again later. It might seem backward, but it’s the opposite of buying stock thinking it will go up in price. With a short, you “sell” the stock with the plan to buy it later at a lower price. You then pocket the difference between what you sold the stock for and what you bought it back for.
- Hedge fund — A hedge fund is an alternative investment tool that uses pooled funds. Hedge funds differ from other funds because they are often restricted to institutional investors or well-established investors. Unlike mutual funds that typically make safe investments around holding well-performing stocks, hedge funds tend to make risky investments, such as shorts, and then hedge their bets with more traditional investments.
- Clearinghouse – When you buy a stock, you’re not buying from one individual or company. Your shares were listed by multiple parties with a clearinghouse. When you use your stock app to buy or sell, the app contacts a clearinghouse and the clearinghouse then validates the transaction.
- Broker – A broker is someone, or a company, who buys and sells stocks on your behalf. They have relationships with clearinghouses to buy and sell bulk amounts, not just the handful you might be trading.
- Security – A security is a financial tool that has some understood value. A security can be equity by owning stocks or credit in the form of bonds.
- Derivatives – Derivatives are contracts that get their value from securities. So a short is a derivative that gets its value based on the stock being shorted. It doesn’t have to be stocks, however; a derivative could be based on bonds, commodities, or currencies, among other securities.
- Market Manipulation – Pretty simple really: any act that intentionally inflates or deflates the price of a security. The most common form is the “pump and dump”: buying up cheap, unknown stock and spreading rumors about how amazing it is going to be, then dumping the stock when it’s near the peak so you profit while everyone else realizes it wasn’t a good stock.
So what happened with GameStop?
We all heard a lot about the stock market in the last few months. And learned that some companies still exist—hello, Blockbuster! No matter how much we heard, it was hard to learn and understand what was happening. Between industry-specific language and speculative rumors and outrage-based screaming, much of the reality of the situation got murky.
The rundown is this: a few savvy hobby traders noticed a few hedge funds were shorting GameStop stocks. They then bought up as much as they could, knowing that the hedge funds would have to buy the stock later.
Some of these early investors shared the news on social media, primarily on the website Reddit. From there, people started buying whatever they could. The law of supply and demand took over, driving up the price of GameStop stock.
This is about the time things started to get confusing. Big institutional investors, hedge funds, were at risk of insolvency, or running out of money. When billion-dollar companies start to be one-dollar companies, people get upset. (Other, bigger hedge funds came in and bailed them out, anyways.)
Rumors of market manipulation started. Was it market manipulation? No. People can buy stock for whatever reasons they chose. In this case, some investors saw the shorts and an opportunity to cash in. Others looked at the data and some restructuring that GameStop had done, concluding the company has future potential. Some people bought because it was funny. Others bought to stick it to the hedge funds, seeing them as the enemy.
But some platforms suspended or restricted trade volume! True, they did. Robinhood caught heat for restricting trades. Their reasoning, however, is sound and logical: they didn’t have the capital to back the trades.
Buying stock through an app starts with you telling the platform what stock you want. The platform then goes to a clearinghouse and says what they want to buy and at what price. Someone somewhere else has their stocks for sale, the deal is made, the clearinghouse transfers the stock to you through the platform, the platform takes money from your account. Make sense? No?
Think of it like this: you go to your local store to buy something. It’s not in stock, but they can order it. The store orders it from their distributor and pays the distributor. You then come back and pay the store and pick up your order. The only difference with online stock trading is it happens almost instantly.
The problem was Robinhood didn’t have enough capital to keep up with the volume of trading. The clearinghouse wouldn’t pass the transactions because they were worried they wouldn’t get paid. In order to stay afloat as a company, Robinhood had to restrict transactions for GameStop on their platform.
After topping out at nearly $400, the bottom fell out and prices dropped. Much like the pet rock, hysteria drove sales.
The lesson to be learned: don’t buy stocks just because of hype. People were buying right near the top of the stock’s price, getting caught up in the concept of taking down giants. Celebrities bought in, rumors were rampant, and the whole thing got out of hand. Some people made a lot of money, others lost a lot. Be careful.Go to main navigation