Hedge funds that shorted GameStop (GME +1.53%) stock have a big problem. There's not enough stock to go around to let them cover their positions, so as the video game retailer's shares race higher day after day after day, the hedge funds are hemorrhaging money.
Financial analytics firm S3 Partners says short-sellers lost almost $1 billion on GameStop stock last year and are already down over $5 billion so far this year. They are losing more daily as they're caught in a vortex from which they can't escape, though there is a way out and it's GameStop itself that could save them. If it does throw them this life preserver, it could massively benefit the retailer, too.
Image source: Getty Images.
Short end of the stick
What's happening to the hedge funds right now is a short squeeze of gargantuan proportions, or what's being referred to as a "gamma squeeze," which is an acceleration in the price of a stock as investors buy up options contracts in ever-increasing amounts.
The GameStop squeeze is interesting because institutions bet so heavily against the retailer's stock price, meaning they expected the price to fall, that when Reddit traders realized the number of shares sold short exceeded the number of shares outstanding, they banded together to buy out-of-the-money stock options.
That forced the money managers selling the options to buy the underlying stock to hedge their risk, which caused GameStop's stock to rise, fueling even more options buying and causing the market makers to buy ever-greater amounts of the underlying stock.
The feedback loop has sent GameStop's stock soaring almost 800% this week and over 13,000% so far this year.
Name your price
Unfortunately, while some short-sellers were able to close out their positions, some at a complete loss, many others are stuck. Because almost 130% of GameStock's float is still sold short -- "float" is the number of shares available for trading -- there's no way short-sellers can cover because there's just not enough stock available.
Yet in a tweet, ZeroHedge's "Tyler Durden" argues there actually is a path to salvation, one that allows the shorts to get out of this mess while also enriching the retailer at their expense.
The only wait out of this for the shorts may be to beg for the company to sell them stock. And GME can name any price
— zerohedge (@zerohedge) January 28, 2021
Durden says GameStop is holding all the cards and has an ace in the hole, too: It can set any price it wants for an equity offering and short-sellers would gladly pay it to stop the bleeding. He concludes, "One wonders if this time next year GME won't have billions and billions in cash on its balance sheet."
The path to growth
GameStop could certainly use the money. It ended the third quarter with almost $450 million in cash but has a long slog ahead of it to transition to a growing business again.
A lot is riding on the video game console upgrade cycle that launched in November when Microsoft and Sony released the next generation of Xbox and PlayStation consoles. While that was expected to be a short-term salve, activist investor Ryan Cohen, founder of online pet supplies leader Chewy, was worried management would use the console cash infusion as a justification for continuing with the same strategies that got the retailer into its current trouble.
But GameStop seems to have gotten the memo and appointed Cohen and two others to its board of directors to help chart a new course for the company.
Hoist by their own petard
Issuing stock would help pave the way for growth, but it would come at the expense of existing shareholders who undoubtedly would not appreciate bailing out investors who were just actively trying to undermine their positions.
The SEC also looks askance on companies selling new stock to short-sellers. Rule 105 of Regulation M prohibits such sales under certain conditions because it upends the "independent pricing mechanisms of the securities markets."
While squeezing the short-sellers to the tune of hundreds of millions -- or even billions -- to finance future growth would feel satisfying, it's ultimately just a short-term salve. Management should be thinking long-term, not just exploiting momentary advantage.
There's nothing wrong with hedge funds coming out on the wrong end of a trade every once in a while, and they certainly wouldn't bail out management if the tables were turned. Even if it was permitted by regulation, it would be outweighed by the harm caused to existing long investors.
