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Everyone’s Laughing About GameStop, And Perhaps Justifiably So. But There’s A Flip Side To The Story

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Amateur investors chatting it up on a Reddit thread have managed to drive GameStop’s stock up more than 600% over the course of the week. While the unexpected surge in the stock price has generated dozens of memes and forced out some laughs, the frenzy could have some unintended consequences.

Hedge funds that shorted companies like GameStop and AMC are now finding themselves under the gun after a Reddit thread known as “WallStreetBets” (WSB) fueled buyers to flock to the mediocre stocks. The stock burst has spawned a series of memes and reactions from amateur to experienced investors who appear to be enjoying the booming market, albeit temporarily.

It may be all fun and games now but when big time investors need to cover their bets, it could send ripples through the market.

“If you’re getting killed on your shorts and need to close those out and reduce overall exposure, you’re going to go first to big winners that have done well,” George Pearkes, global macro strategist at Bespoke Investment Group LLC said, according to Bloomberg.

Nervous hedge funds have quickly begun cutting back on risks as they’re now on the line for massive potential losses.

When an investor shorts the market they do so on margin, and when they’re forced to cover their shorts, like what the market is seeing now, they’re forced to raise capital to pay it. While small-time investors might not feel the wrath of this squeeze, big time investors are likely to cover their margin by selling their long positions, which are most likely leveraged. If enough investors begin tapping into their long term positions to cover their losses, the market could see some other unintended fluctuations.

Gross leverage, on Monday, which gauges whether a fund can meet its financial obligations, experienced the largest active reduction since August of 2019, according to the report. (RELATED: Biden Administration Is ‘Monitoring’ GameStop Stock Trading, White House Says)

New data shows investors who shorted GameStop lost $917 million on Monday and $1.6 billion on Friday, according to CNBC.

Investors will also be left with worthless stocks once the market adjusts and begins to reflect the actual value of GameStop and others. Investors left holding GameStop may experience the same infamous Tulipmania bubble that Dutch investors experienced nearly 400 years ago.

During the 1600’s in Holland, speculation about Tulip bulbs drove the prices of the flowers to new heights. However, by the end of 1637, tulip prices began to fall because a lot of people had bought the bulbs on credit, hoping to simply repay their debts once they sold the tulips. But once the tulips lost their value, tulip owners were forced to liquidate their assets and declare bankruptcy in the process, according to Investopedia.

While the economy wasn’t crushed, it did undermine social trust in the market and people’s willingness to trust who could pay their debts.

With the GameStop bubble, it seems likely a similar scenario could occur.

The WSB reddit thread has more than 3 million Reddit users known for high-risk gambled and memes, once losing $50,000 of borrowed money on Apple puts.

But just eight days ago a Reddit user by the name of “gardeeon” pointed out that more shares of GameStop were shorted than were actually available on the market. WSB users quickly began buying up the shares which drove the stock price up and forced hedge funds and billionaires to cover their shorts before they lost more money.

This practice is known as a “short squeeze” which happens when a stock jumps sharply and forces traders who bet the price would actually fall to buy the stock in order to prevent more losses. As investors start a mad-rush to buy the stock the price is pushed even higher.