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The Best Interest » The GameStop Short Squeeze Explained: 10 Questions and Answers

The GameStop Short Squeeze Explained: 10 Questions and Answers

You have questions, I have the answers. Let’s talk through the GameStop short squeeze of January 2021.

1) Ok…What the Heck Happened?!

Let’s start with the bare basics of the GameStop short squeeze. We’ll get into the details later.

Some billionaire hedge funds made sophisticated bets. Nothing wrong with that.

Then a bunch of normal people on Reddit got together and said, “Hey…we can actually gang up on these billionaire hedge funds and beat them at their own game.”

So they did.

The normal Redditors executed their strategy and it worked. That in itself was dramatic and newsworthy. The Redditors’ bets made billions of dollars at the expense of the hedge funds.

The GameStop Short Squeeze Accelerates | The Motley Fool

But then the story took another turn when certain “establishment” institutions intentionally hampered the Redditors’ cause. It felt like “the man” was beating down “the underdog.”

Money, drama, anger, politics. That’s the basic overview. Let’s get into some details about this GameStop short squeeze.

2) Who are These Different Groups?

Let’s introduce all the characters from the GameStop short squeeze.

The two main billionaire hedge funds in this story are Melvin Capital and Citron Research. Some consider them antagonists. To me, they are simply players; neither good nor bad.

Melvin and Citron made big (and risky!) bets against the company GameStop. GameStop is a retail store that sells video games and related products. Melvin and Citron believe (possibly correctly) that GameStop’s long-term prospects are bad. We cover these bets in Q&A #3 and #4.

Reddit is an online message board. A group of Redditors called WallStreetBets wanted to take advantage of Melvin’s and Citron’s risky bets. One Redditor in particular—username DeepingF***ingValue—made a $40,000 bet against Melvin/Citron than turned into $40+ million.

Many of the WallStreetBets (or WSB) Redditors use an app called Robinhood to trade stocks for free. We’ll come back to Robinhood and their partner Citadel in Q&A #6.

3) What’s a Short?

The billionaire hedge funds’ “sophisticated bet” was to short GameStop stock. The mechanics of a short are straightforward.

If you think a company is good, you buy the stock for the long-term. You go long. If you think a company is bad, you can short it.

Let’s look at an example between me and Shorty. Shorty wants to short the Best Interest stock. Why? Because Shorty believes the Best Interest is going downhill and fast! Boo Shorty. Boooo!

I have 100 shares of the Best Interest stock (ticker symbol $BENF). In order to short the stock, Shorty and I enter into a contractual agreement.

Benjamin Franklin - Wikipedia
Ben F., the CEO of $BENF

Shorty will borrow my 100 shares of $BENF, currently worth $10 each. We agree on a timeline—say, 60 days. After that 60-day period, Shorty owes me my 100 shares back.

Over those 60 days, I’ll charge Shorty a small borrowing fee. That’s how I make my money in the agreement. Shorty also has to put down a deposit called a margin requirement, worth 150% of the deal. We need to make sure Shorty has the funds to cover this deal if it goes badly for him (we’ll talk about that in Q&A #4).

After our agreement begins, I give Shorty my shares. He immediately sells them for $10 each and gains $1000 in cash. And then Shorty waits.

In Shorty’s ideal situation, $BENF stock will drop. Let’s say it drops to $5. Shorty will then re-purchase the 100 shares at $5 each, costing him $500. He’ll return to 100 shares to be, and he’ll keep his $500 profit (minus the little fee he owes me).

Shorty shorted the Best Interest and he won.

P.S. Here’s a great article about the “Big Short”

But this story is about the GameStop short squeeze. Let’s talk about that.

4) What’s a Short Squeeze?

Shorty owes me my stock back after 60 days no matter what the price. He sold at $10, but he has to rebuy my stock after 60 days whether it’s at $5/share, $10/share, or $100/share.

That’s why shorting is risky. There’s no limit to how high a stock can go. Perhaps demand for $BENF goes through the roof while Shorty is shorting it. There’s no limit to how much money Shorty might lose.

And to make matters worse for Shorty, his act of re-purchasing the stock adds more demand to $BENF. Shorty himself will drive the price higher, costing him more money.

If the price gets high enough, I might margin call Shorty. Remember that deposit Shorty put down, called the margin requirement? It has to be 150% of the short bet itself (or $1500 for starters in our scenario).

But if the price of $BENF goes above 50% of the original price—or above $15—then Shorty’s original $1500 deposit no longer covers his potential losses. Shorty would have to put down more money. That’s a margin call.

Shorty’s short bet is now squeezing him out of money. The more the price of $BENF increases, the more Shorty will get squeezed. Even if he has faith that $BENF will eventually drop to $5, he might run out of money first from all the margin calls.

What is a Short Squeeze? Meaning and Example | IG EN

That’s a short squeeze.

The GameStop Short Squeeze

That’s what happened in the GameStop short squeeze.

In the GameStop short squeeze, Melvin and Citron (and possibly others) shorted GameStop’s stock. They borrowed GameStop, put up a margin requirement, immediately sold their shares, and waited for GameStop prices to drop (before eventually re-purchasing and returning the borrowed shares).

The WallStreetBets crew said, “If we all start buying tons of GameStop stock, we’ll drive the price way up! The billionaires will pay tons of margin calls. And then they’ll have to re-purchase the stocks—probably from us!—at huge prices. We’ll make money, and the billionaires will lose money!”

And that’s exactly what happened.

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5) Is This Based on Fundamentals? On Emotion? Something Else?

Is the GameStop short squeeze based on business fundamentals? Absolutely not.

The stock went up 2000%, but the company didn’t get fundamentally better by 2000%. That’s easy.

But it’s not really based on emotion, either. Nobody involved believes that GameStop is truly a revolutionary company worthy of huge stock prices (like, for example, how many investors view Tesla).

Instead, the GameStop short squeeze is based purely on market mechanics. Think of shorts and short squeezing as a weird rule in the game of investing

Once in a while, people see an opportunity to take advantage of that rule.

6) What is Robinhood and Citadel? And Why Are They Involved?

The story could stop here and it would be dramatic. The GameStop short squeeze was making headlines before Robinhood and Citadel got involved.

Robinhood is a trading app that enables free stock trading. Robinhood’s claim is that they give stock market access to average Joe and Jane. You know—rob from the rich, give to the poor. You can buy stocks, bonds, funds, SPACs…lots of stuff.

The WallStreetBets crowd used Robinhood to purchase their shares of GameStop. And then, for “unknown” reasons, Robinhood halted trading on GameStop. They forbade users from purchasing more GameStop shares. Why would Robinhood do this? Why indeed.

Let’s switch gears to Citadel.

Citadel a hedge fund specializing in high-frequency trading. When average Joe makes a trade, Citadel reacts in the blink of an eye. They see the trade proposal, zip around the rest of the stock exchanges, make the same trade as average Joe, change the price by a fraction of a penny, and then execute average Joe’s trade.

Citadel keeps the fraction of a penny as profit. Joe barely notices the price change.

Citadel does this millions, billions, trillions of times a day. They make huge money.

Why is Robinhood free? Because they give Citadel access to their trade information. Ah ha! Citadel makes their fractional pennies from Robinhood traders.

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And in other news, Citadel made a $2.75 billion investment into Melvin Capital early last week, before Robinhood shut down GameStop trading.

Wait a second…

Why People Are Pissed at Robinhood

I’m a simple index fund investor. This GameStop business doesn’t affect me at all.

But the stock market is a game. It has rules. I’ve chosen as boring of a strategy (index funds) as I can.

The hedge funds chose risky strategies. Still within the rules.

The WallStreetBets people chose a strategy to burn the hedge funds. Again, all within the rules.

And when Robinhood halted trading on Gamestop, they changed the rules.

You can call it cheating. Or welching. Or reneging.

Changing the rules after the money has been laid down on the table—that’s some bullsh**. That’s why everyone is upset at Robinhood. And they changed the rules in favor of the billionaire hedge funds. Extra bullsh**.

It’s like we’re all at a poker table. I’m sitting out this hand because it’s way too risky. But I just saw another player cheat. It’s all the same game, all the same rules…and that guy just cheated.

So even though I’m sitting this one out, I’m still upset at the cheating! Who says they won’t cheat me in the future?

7) Is This Legal? Is It Manipulation?

Is the GameStop short squeeze…ya know…legal?

This largely remains to be seen.

Some people are already taking Robinhood to court over their decision to shut down GameStop trading.

Others are suggesting that the Securities and Exchange Commission is looking into WallStreetBets to see if their group effort meets the bar for illegal market manipulation.

For what it’s worth, many legal experts already suggest it would be impossible to prove wrongdoing by WallStreetBets. They’re a “mob of uninformed, unsophisticated  retail traders.” Hardly evil geniuses.

8) What Are Options and Options Trading?

Many WallStreetBets users made huge amounts of money in the GameStop short squeeze through options and options trading. To explain options, I like to use a story about cookies.

You really like cookies. Right now, cookies cost $1.00.

But in your cookie-loving brain, you’re worried. You think the price of cookies might go way up to $2.00.

So you make a deal with the cookie baker.

You’ll give the baker an extra $1.00 right now. In exchange, the cookie seller makes a promise. He promises that for the next month, he’ll sell you up to ten cookies for $1.25 each.

If you’re right, and the price goes up to $2.00, your promise will “save” you 75 cents per cookie!!

If you want, you could turn right around and re-sell your $1.25 cookies for $2.00, and make an immediate profit.

If you’re wrong and the price stays at $1.00, then your promise expires at the end of 1 month and you’ve effectively lost the extra $1.00 you spent on the “promise.”

The promise = an options contract

Cookies = asset (like a stock)

This is an example of a call option. If the cookie dealer was thinking that cookies would decrease in price, he’d buy a put option instead. Example: an agreement to sell cookies at 80 cents, even if the market price were to drop lower than 80 cents.

Many WallStreetBets people bought call options prior to the GameStop short squeeze for pennies on the dollar. When the price started increasing, they executed their calls and purchased GameStop shares at a much lower-than-current stock price.

9) Wasn’t the GameStop Short Squeeze an Easy Way to Make Money?

I think your young years are the best time to invest. That said, the GameStop short squeeze was a highly risky way to make money.

Sure, some Redditors made millions of dollars or 50x’d their investments in less than a week.

But other people bought in far too late, after the stock had already jumped in price. They are left “holding the bag.”

I think the GameStop short squeeze was entrancing to watch. But I stayed away like the plague (too soon?).

I’m but a simple index fund investor.

10) Who Were the Winners and Losers?

How did all the characters fare from the GameStop short squeeze?

Melvin and Citron lost big. They are billion-dollar funds, and some estimates are that they lost more than half of their funds’ values before eventually closing out their positions.

Why couldn’t they just wait for the price to eventually fall?

Because they were getting margin called (see Q&A #4). They couldn’t risk the potential of the price going even higher.

Many Redditors won big, and on average they definitely won. I’m sure many also lost big. Most had no idea what they were doing and were following the crowd.

GameStop certainly won, at least in the short term. Presuming their company did the smart thing and sold some shares into the market, they likely raised a huge amount of capital that previously would’ve been impossible.

Robinhood lost—possibly forever—from the GameStop short squeeze. Their public image has been tarnished, perhaps irreparably.

Citadel…it’s hard to tell. I’m not terribly worried about their billions, though.

Time to Sell?

That’s it. Ten basic answers about the GameStop short squeeze. What a whirlwind.

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10 thoughts on “The GameStop Short Squeeze Explained: 10 Questions and Answers”

  1. Another excellent article, thanks for the great summary.

    I may add that the winners and losers haven’t all been identified, because the game’s not over. GME is still incredibly inflated and lots of the WallStreetBets folks still have shares. And, as I understand it, many of those shares were purchased on margin.

    It will be interesting to see who the winners and losers are when the game is over and GME is back to $10 or $20 per share. The a mirror image of the mechanics that led to the short squeeze exist for many WallStreetBets folks. They’ve got margin, and when GME drops, many could get margin called simultaneously, putting immense downward pressure on GME and wiping out these portfolios.

    I suppose, for the WSB folks who have huge short term gains, it’s not that big a deal. They created and lost a big fortune on paper in a month… But for those that got in when GME was already inflated, they stand a real chance of being much worse off after this is over that they were before.

    1. Hey Jay! Thanks for reading.

      *Fantastic points!!*

      I completely agree. The dust has not settled. And there is 0% chance that the only losers are hedge funds. We’ll hear stories from naive investors who thought they were MOON’ing, thought they were fighting the good fight, thought it was easy money, etc…and they’ll lose everything.

      Now, *hopefully* they lose $1000 or $2000. While it sucks, that’s not a terrible way to learn a lesson.

      Planet Money’s most recent episode is about a Redditor who put $200,000 into GME, and then liquidated his 401k to add more. He sold and made $4 million profit. But how many people did something that risky (or stupid) and are still holding?!

      Let’s see where the dust settles…

  2. Great summary Jesse! This is a good primer for what’s going on with $GME for folks only vaguely familiar. I sent it over to my buddy who was asking questions. I appreciate how we’re often on the same page with different topics. 🙂

    As you mentioned, it’s been “entrancing to watch”… but I’m really worried it’s going to be entrancing like a slow moving train wreck.

    I hope it’s not.

    I really hope it’s not.

    But there *seems* to be so many folks out there with their last dollar tied up in a highly speculative trade… and usually that doesn’t work out well for those folks being sold hope and a dream.

    Maybe this time will be different, but I can’t imagine it will be. And for someone who’s been trying to push the slow and steady process of financial independence—like you, with diversified index funds—it just makes me so sad.

    I don’t know how it could, but I really hope this turns out OK. Just not bad.

    Thanks for the overview.

    1. Thanks Chris!

      No no, I defintely think you’re right.

      This is going to be the classic “large movie theater with a small door.”

      We’re already seeing the small door on the way up, right? The hedge funds are getting squeezed to fit through.

      We’ll see the same on the way down, I’m sure. And it’ll be regular people holding the bag.

      As I mentioned to Jay in this Comment section…there are worse lessons than losing $1000 on this bet. It’ll be eye-opening.

      But I share you fears that many people are our age and YOLO’d their life savings on this meme once it already topped. It’ll be hard to put words to that level of regret after the fact.

  3. Great post, Jesse! It is important for people to understand what they are buying before they do so. You provide great explanations, so readers will have a sense for participating in this type of market, whether it be taking the bet on the long (up) or short (down) side.

  4. George B Stackhouse IV

    Great article. One thing that is lost in the current version of the story is who the players *might* be. WSB is a forum, and (just like the rest of the internet,) not everyone is who they pretend to be.
    I would be surprised if there weren’t rival hedge funds on the “squeeze” side of this story also.
    The “short squeeze” has been around for centuries, and hedge funds employ smart young people also who would be lurking on WSB.

    So this may not really be 1000 little “Davids” vs 2 “Goliaths”. Could be 1000!little Davids+17 other Goliath billionaire hedge funds vs 2 Goliaths!

    Time will tell…

    1. Hey George, great point. I’ve heard some smart people say the same thing you’ve said. Reddit’s anonymity makes it so you never really know who is doing the talking. And some of the strategies employed by the “leaders” of the movement show that they had an expert-level in-depth understanding of market mechanics.

  5. Great post!

    Interesting that in the days that followed the media hype on wallstreetbets retail investors “winning” this war it comes out that other hedge funds were piling in even more money and ended up making the most as well as putting some of their competitors out of business. The system is pretty much rigged against individual investors. Wall Street always gets their money.

    I am a boring index investor like you! This is the only way to “win” the game in the long run…..

    1. Hey Int Inv! Yes, I know exactly what you mean! A bunch of the smart podcasts that I listen to mentioned a similar sentiment. “Wall Street always wins.”

      I’ll take my low fees and average returns and be perfectly happy with them 🙂

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