Confused by the last few days of headlines about Redditors bankrupting hedge funds via the Gamestop share price? Here we explain in plain English what’s happening and why we should all care:

What is the stock market?

The stock market is – as you’d imagine – a market for financial products. People normally think of “the stock market” as a market for stocks and shares, so we’ll explain this first.

What is a share or stock?

A share (British English) or stock (American English) is an agreement between the owner of a share (known as a shareholder or stockholder) and a company. This agreement stipulates that the shareholder owns a chunk of the company in exchange for a certain amount of money. In previous decades, shares were physical pieces of paper. Nowadays, shares are electronic. Shareholders are compensated financially by a company when it does well in the form of regular financial payments called dividends – in other words, when a company is making a profit, shareholders will receive a chunk of that profit.

Stocks and shares are traded on stock exchanges. The most prominent stock exchange in the UK is the London Stock Exchange (LSE). The US has several prominent stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq.

How do people make money on the stock market?

There are two main ways people make money on the stock market. The first comes in the form of growth investing. This involves investors making educated guesses as to which businesses are likely to do well. This is usually a long-term strategy, with shareholders retaining a share or multiple shares in a company for many years or even decades. If you’ve ever heard people saying that if they’d invested a few dollars in Apple in the 1970s, they’d be a millionaire now, that’s a reference to this style of investing. Long-term investors are essentially betting that a) a company’s share price will go up over a number of years as the company becomes more profitable or innovative; and b) the company will consistently make a profit, which will reward the shareholder with a dividend. This type of investing is favoured by Warren Buffet, who historically has advised people to stay clear of the second type of investing.

This second type of investing is more relevant to the GameStop controversy. It involves making educated guesses as to whether share prices are going to move up or down over the short-term. This is generally referred to as “speculative trading” or even “day trading” among pundits.

Share prices move for an array of reasons, but as a rough rule, if loads of people are buying a share its price will go up – and if loads of people are selling, its price will go down. This happens in real time, and trading floors in the financial sector are often wired to try to reduce the physical distance the internet connection has to travel, to try and provide the most up-to-date share price figures for their employees. If a person accurately guesses a share price will go up over the course of the day, they can buy a share at its low-point and sell it a few hours later once its price has risen, pocketing the difference.

There’s a great deal of luck involved in this kind of short-term investing, but there are ways to make educated guesses as to the short term trends of share prices. To give one example, if a company’s share price is soaring but financially the company is struggling to pay dividends to its shareholders, this may be a sign that the share is overvalued – in other words, is being valued artificially higher than the actual value of the company. When this happens, it might be a sign to sell stock or avoid buying it, as overvalued shares tend to reduce in value when given enough time.

Not all indicators of share price movements are hidden in the financial news columns: political events and even mainstream media events can have an impact. When Elon Musk smoked cannabis on Joe Rogan’s popular YouTube podcast, the stock price of Tesla subsequently plummeted.

Over the last few decades, the financial sector has grown increasingly innovative in providing new ways to make bets on the movement of the financial markets. It is now possible to make money by betting that a share price will go down as well as up. There are a few ways of doing this.  The term most used in financial columns for this phenomenon is “short selling.”

What is short selling?

Short selling is a way traders can make money when the price of a share goes down. Traders do this by going to a stock broker and effectively renting a set number of shares – we’ll say ten for the purposes of this discussion. The broker lets them do this for a fee. The trader promises to return ten shares to the broker after a period of time. The broker gains because their ownership of shares will ultimately remain the same and they gain from the transaction fee. Any dividends earned by the trader while they are borrowing the shares must also be returned to the broker.

The trader, now armed with ten rented shares, then sells these rented shares immediately – if they think the price of the share is going to go down, then they will make the most money if they sell shares at their highest value (ie, straight away). Once the share price has dropped, the trader is obligated to buy ten shares at this new (lower) price, because they promised the broker they’d return the ten shares. So they do this, and return ten shares to the broker.

The trader pockets the price difference between the ten shares they sold and the ten shares they bought back. So, in a sentence, short selling involves borrowing stocks for a fee, selling them at a high price, and buying them back once they’ve hit the lower price that the trader predicted in advance. In essence, it’s turning a fall in the share price into a profit.

Another, more volatile, way of betting over share prices involves something called spread betting or CFD trading. A spread bet involves betting a set amount of money that the value of a share will go up or down a point, without owning the stock or share itself. Some traders prefer this kind of instrument as it avoids paying stamp duty in the UK, unlike standard share trading which incurs this form of taxation. This type of bet can be highly lucrative in the short term if done well, but CFD markets are notoriously volatile.

It is possible to bet on the movement of other financial indicators, in addition to stocks or shares – such as foreign currencies, commodities such as gold, and indices (baskets of stocks or shares that are rough indicators of how an economy is performing). Sometimes this can turn a tad ugly, with investors making a killing by betting that the entire economy is to have a downturn.

What does any of this have to do with GameStop?

GameStop is one of the most shorted stocks on the US stock market. This means speculative traders had been expecting retail gaming companies such as GameStop to underperform, in part because the pandemic hit retail enterprises hard. Large numbers of speculative traders had been short selling GameStop stock. They were guessing GameStop’s share price was going to go down.

However, GameStop’s share price came under something akin to an external attack from users of the microblogging website Reddit. More specifically, a subsection of the Reddit site called r/Wallstreetbets decided to increase Gamestop’s share price by buying its shares in bulk. This is sometimes called a “short squeeze” or a “gamma squeeze” – a temporary hike in the share price due to speculative trading. And as we’ve already explained, large numbers of traders buying a company’s shares will cause its price to shoot up. Which it did: GameStop’s year low was $2.58 per share but its high in the last week reached as much as $347.

So why are hedge fund managers struggling?

First, it’s necessary to explain what hedge fund managers are. They are, as the name implies, a form of financial manager. The term “hedge fund” comes from the financial term “to hedge”, which means to manage financial risk to ensure a person always wins, on average, in their stock market trades. Hedge fund managers act a bit like stock traders by proxy: they bet other people’s money for a living and take a cut of the return.

They are trusted traders that investors give their money to in the hope they will see a large return as a result of the financial manager’s superior knowledge of the stock market. Some economics studies have questioned whether this superior knowledge always leads to good returns, but more on that another time.

While we often think of hedge fund managers as extremely rich, the funds they manage aren’t always those of multimillionaires. It isn’t unusual for ordinary working people’s retirement funds to be tied up in stock market schemes that may involve a hedge fund manager.

Unfortunately, in the case of GameStop, hedge fund managers have been involved in the recent short selling of GameStop stock. They had been betting that GameStop’s share price would stay low and would continue to decline so that they could buy stock cheaply to repay GameStock shares they had borrowed. Normally, this wouldn’t be a problem – and in the current economic climate it wasn’t a particularly silly bet. However, because the share price has massively increased due to Redditors’ actions, hedge fund managers are now faced with the impossible situation of having to buy GameStop stock at rates much higher than when they borrowed to fulfill their obligations as part of their short selling schemes. Because scores of internet nerds have been buying into GameStop, and hedge fund managers have also been forced into buying in, this has further increased the GameStop stock price. So hedge fund managers are suddenly losing a lot of money. They’re being hit with a double whammy: losing money after trying to short sell GameStock shares, and in being forced to inflate the share price even higher while doing so.

What happens now?

The Reddit page responsible for the GameStop price hike has gone private, which may mitigate some of the damage, although it’s possible other stocks could be targeted in a similar way in future.The financial establishment has powers at its disposal if and when this happens: in the case of GameStop, the New York Stock Exchange has halted trading nine times, in part triggered by a White House alert. What happens long-term, however, remains to be seen. Democratic politicians such as Elizabeth Warren are demanding that the Securities and Exchange Commission (one of the US financial regulators) steps in. It isn’t impossible that we will see financial regulators investigate or look into new measures to tackle stock market volatility.

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