The GameStop Short Squeeze and How It Happened

EconBuff Podcast #24 with Eric McKee

https://youtu.be/rbudb_rf1b4

Dr. Eric McKee talks with me about the short squeeze with GameStop stock happened. Dr. McKee walks us through what short trading is. We discuss the details of how short squeezes happen. We explore how hedge funds work and Dr. McKee explains why hedge funds use shorts. Dr. McKee argues the confluence of zero dollar commissions, the pandemic, stimulus checks, and a little bit of good news for GameStop caused the short squeeze event. Dr. McKee elaborates on how RobinHood works and how they were likely influenced by their clearinghouse. Dr. McKee discusses why RobinHood stopped their retail investors from trading the way the investors were and explains how there could be so many GameStop shares being shorted at one time. Finally, Dr. McKee lays out how it is the Melvin Capital hedge fund could lose 4 billion dollars on a seemingly insignificant stock like GameStop and we explore how Dr. McKee views the nature of the sub culture in the r/wallstreetbets sub-reddit.

Photo by Joshua Hoehne on Unsplash

Transcript:

LEE STITZEL: Hello and Welcome to the EconBuff Podcast. I'm your host, Lee Stitzel. With me today is Dr. Eric McKee. Eric is a professor of finance at West Texas A&M University. Eric, welcome.

ERIC MCKEE: Yeah, thank you, Lee. Thank you for the invitation. It's a real pleasure to be here.

LEE STITZEL: So our topic today is the GameStop short squeeze, the Robinhood trading app, and all the stuff that happened on Reddit. Really, the reason that I wanted to bring you on today is to get into this technical finance stuff. I get questions from my students: what's going on here? And I have these grand economic answers to them, but I think there's room for a lot of exploration of the interesting details that are going to be happening. So I want you to start us off. This episode is centered around this idea of short trading, or a short. Can you tell us what short trading is?

ERIC MCKEE: Yeah. So normally you would buy low and then sell high, and with short trading you sort of do the reverse. You sell first at a high price, and then you buy it back later, hopefully at a lower price, and then you get your profit that way. Now, you're selling shares you don't actually own, so you have to borrow them from someone else who currently owns them, and you have to pay interest on that. It's generally a much riskier strategy that only very sophisticated or professional traders really should be doing, or do at all. So that's sort of what short selling is in a very broad context.

LEE STITZEL: Is this like the opposite of going long? So people say, “going long,” they just mean, “I'm just going to buy it, and then the price is going to go up, and then I'll sell it and benefit.” That's going long?

ERIC MCKEE: That's the normal way you would go long. There are some other exotic ways you could go long or go short, but yeah, you're basically either buying the stock and hoping it goes up, or you're selling it hoping it goes down.

LEE STITZEL: So the reason that short trading is really a sophisticated thing is I'm somehow selling something I don't own. So I think everybody's alarm bells went off when you said that. You're like, wait a minute, I sell it first? Don't I have to have it before I sell it? Can we delve into that borrowing thing a little bit? So you have this idea and you say, “I think this stock's going to go down, so I need to sell it first.” So if I want to sell it, I've got to borrow it, and Lee's over there and he's got a stock. What happens?

ERIC MCKEE: So if you have, say, a brokerage account, a lot of times how you'll be able to short sell is other people who have accounts at that broker own stock in that company, and the broker can take that stock, lend it to you, and then you sell it and have an open position with the brokerage account or with the brokerage firm. And then if that person says they want to sell their stock, there are other people who also own that stock, and then they just sort of swap shares to make things good. For the big guys like the hedge funds, they will tend to have a different way of borrowing shares. But if you're trading with a brokerage account, that's probably how the short selling would work for you.

LEE STITZEL: So if we're talking about a hedge fund and having another way to go about doing this, are we equipped to understand that? Could you explain that to us, or do I need to walk us a little bit further down the path before you open up that can of worms?

ERIC MCKEE: Yeah, I don't know too much about where they borrow from. Hedge funds tend to be trying to be really secretive about their strategies, because if it gets out, then all the other hedge funds will pile in and they won't be able to make money anymore.

LEE STITZEL: So are they specifically trying to hide from hedge funds, or are they also trying to hide from sort of a more general use of that information? And are those hedge funds now adding Reddit to their list of people to hide from?

ERIC MCKEE: They definitely try to hide from anyone who might be trading on it. Hedge funds are probably the ones who could most easily exploit that information, but more traditional investors could also be trying to copy them too.

LEE STITZEL: So I'm going to go off in the weeds for a moment, because this idea just popped into my head. You're a Ph.D. in finance, so in theory a hedge fund could come hire you. Is part of your compensation structure going to be centered around secrecy? Like they'll say, “We'll fire you if you let our secrets out,” in order to build this kind of, what would you call it, secrecy that the hedge funds are going to...?

ERIC MCKEE: Yeah. So first, there are quite a few hedge funds that hire Ph.D.s in finance. One of the largest ones, AQR, is really well known for doing that. So there are a lot of Ph.D.s in finance who go into industry and work for places like hedge funds. I didn't try to get a job there, so I don't know the whole details, but they probably have some sort of nondisclosure agreement that they have to sign if their trading strategy is something secret.

LEE STITZEL: So I'm thinking like an economist and saying that must be the type of thing that we would have to pay more to get people into that type of position. I could be wrong about that, right? Because the secrecy aspect could be something that people who work for these funds really don't care either way. I'm sort of thinking like a risk premium type thing. I'm using that in a finance sense, but if you're working in a job that's more likely to get you injured or killed, then you're going to be paid more in order to do that. That's a really funky way to use risk premium, I guess.

ERIC MCKEE: Yeah, they definitely get paid a lot more if you go into that.

LEE STITZEL: Is that because those are very highly skilled people working in very technical positions? Well, obviously it must be, but there's also this element of secrecy, you think?

ERIC MCKEE: I don't know. It's probably both. It's probably a mix of all that.

LEE STITZEL: Like I said, off in the weeds. Okay. So what I'm very interested in now, it's actually, I think, relatively understandable to think about what short trading is and what it's doing and kind of why it would work. I think there's an idea out there that short trading is somehow riskier, or it's more like gambling and less like investing. But to me, at least, the description that you've just given us is a relatively intuitive thing, in the sense of: if I think a stock's going to go up, how do I benefit from it? I buy it now. If I think the stock's going to go down, how do I benefit from that? Short trading seems to be the answer to that. Can you comment generally on this idea of investing versus gambling and how short trading fits?

ERIC MCKEE: So it's definitely riskier. One of the big reasons it's so risky is there is no upward limit, no ceiling, on the price of the stock. You could have a stock price go up to a thousand or ten thousand, and you would still have to buy back that share to return it to the person you borrowed it from. If you bought, the worst you can do is the stock price goes to zero. So there's a sort of unlimited potential loss.

LEE STITZEL: So the people that first got in when GameStop stock was whatever it was, six or seven bucks, if they bought a hundred shares, they could lose six hundred bucks if it went all the way to zero.

ERIC MCKEE: Yeah. There's limited liability. You can't lose more than what you invested if you buy. If you short sell, you could lose everything.

LEE STITZEL: So what's the mechanism that eventually forces me to buy back the stock, and at what price does it happen? Is that only a time constraint? You've borrowed the stock, and so therefore in 30 days you have to return it? Or are there other things, like I can say, “You borrowed my stock through the brokerage firm, and now I demand it back,” and you're like, “But wait a minute, it's four hundred bucks. I don't want to buy it back now.” How does that work?

ERIC MCKEE: It depends on the terms of your loan contract, basically. But it's really standard to have some sort of predetermined price limit, and then the broker will call you up and say, “Hey, you need to put up more cash as collateral, or you need to close out your position.” And if you don't put up more cash, we're going to close that for you, and they're going to be really mad at you if you force them to do that.

LEE STITZEL: So this is where the squeeze idea comes in?

ERIC MCKEE: Yes. That's part of how you get the squeeze, yes.

LEE STITZEL: So describe to us the mechanics of the squeeze, then, which I think you've laid the basis out for us. Then we're going to want to come around to talk about how this ended up being a squeeze. So in theory there was some number out there, and they were saying, “If GameStop stock ends up getting up to 20 bucks or something, then we're going to have to make you put up more cash on your short.” Are there layers to that? When we get to 100, do they call you again and say, “Okay, now you've got to get more”? Two hundred?

ERIC MCKEE: They do.

LEE STITZEL: Okay. So how do those increments get set?

ERIC MCKEE: It's based on, so it's a loan that you're taking out, and it's a pretty risky loan because of that unlimited loss. The person that you borrowed from will generally force you to put up some collateral, some cash in an account that you can't touch. And if everything goes horribly for you, they will just seize that cash and use it to close out their position. So it's kind of like you have a home mortgage. Your house is collateral. If you don't pay your mortgage, the bank will just take the house and use that to make good their loan. So something like that. But when you're trading with the stock market, things can move really quickly. So the broker wants to make sure that collateral will be enough to cover them. Some percentage limit will be set in that loan term, and if your losses get too high so that most of that collateral is going to be eaten up just taking care of those losses, then you'll get what's called a margin call.

LEE STITZEL: So the margin call is the part where they call you and say, “We need more collateral.”

ERIC MCKEE: Yeah. Back in the old days, or a couple decades ago, you might get a phone call. Probably now you get some sort of electronic requirement. But then you either have to put up cash or you close out the position, or they force you to close out the position.

LEE STITZEL: So if I can step back to kind of the whole cycle, which we're still in the middle of, so it'll be interesting to see how this shakes out, and we're going to ask you sort of where things are at as they stand when last we knew them. But in theory, I know GameStop stock is not going to sit at four hundred for the foreseeable future. So they call me, give me a margin call, and say, “Hey, GameStop stock is up to one hundred bucks. You need to put some more money up.” And I say, “Oh, I really don't want to do that, but it's got to come down.” Then they call me at two hundred, three hundred, four hundred, et cetera. If I can just keep putting up the money, eventually I will ride this out and it will come down. Maybe it doesn't end up shorted, but it's really more of a liquidity problem, necessarily, than the actual way the stock will end up.

ERIC MCKEE: Yeah. You need to have enough cash if you want to keep holding on.

LEE STITZEL: Okay. I do want to talk about the scale of this whole thing eventually, because I think that's what kind of blew my mind with the whole thing. I think I actually said this to my students when they brought it up, and I was like, “How much money can a hedge fund be losing on GameStop?” That turned out to be a really stupid thing to say because of what you've described already, and then I've seen some of the numbers since then. I went back and talked to them actually this morning and kind of described some of this stuff, as far as I know it, which is why I'm really glad to have you here today. So are we good on short trading? Let's keep going with the short squeeze.

ERIC MCKEE: So they happen on occasion, and normally what happens is this stock is being heavily shorted. Lots of people think it's going to go down in the future, and so they all are piling into the short-selling side of the trade. Then there's some sort of positive news about the company. There's buying pressure, pushes the stock price up, a bunch of these shorts get margin calls. Some of them don't have the cash to put up more cash, so they have to close out. They have to buy to return their shares. That's more buying pressure, and then it turns into a positive feedback cycle where every time more shorts are forced out, they buy, it pushes the price up more, there's more cash requirements on the remaining shorts. It just keeps going until all the shorts, or all the shorts who didn't have enough cash, have been pushed out. Then the stock price crashes back down because it's way higher than the real value of the firm.

LEE STITZEL: So this is something that we observe. We're going to probably get around to throwing around words like market manipulation here, but you've just described a relatively organic way for this to happen, given the existence of a fairly high number of shorts.

ERIC MCKEE: Correct. Yes. And actually, in the case of GameStop, they did have some positive news. There's a big billionaire investor, his name is Ryan Cohen, I think. He was very successful in e-commerce. He had Chewy.com, a company that sells pet food, and he made a big investment in GameStop. I think it's about ten percent of their shares he owns, roughly. He got himself put on the board of directors, and a couple of his buddies who are presumably going to vote with him on the board of directors. So that was kind of the positive news that started pushing up the GameStop price. And then once that happens, because it's so heavily shorted, there's all that additional buying pressure from the short sellers who have to cover.

LEE STITZEL: I had not heard that. I've soaked up this story in quite a few different venues, and I hadn't caught that bit of news, which is very interesting to me because the story is, oh, here's this Reddit community and they do this, and then they sort of spark this on their own. But you're actually saying they're piggybacking on a little bit...

ERIC MCKEE: Well, I think, yeah. At least the initial thing, there were people on that Reddit community who thought it was undervalued, and they bought and they were holding. Then more people were piling in, and the stock price was going up, and that was sort of causing...

LEE STITZEL: So the more people that are piling in, is that because of the Reddit community, or is that because of the Ryan Cohen news?

ERIC MCKEE: Both. Probably both.

LEE STITZEL: Yeah, so this really is a confluence of events.

ERIC MCKEE: Yeah. It wasn't just retail traders piling in. There was some legitimate positive news for the company.

LEE STITZEL: Yeah. So you're not going to have an answer to this, because it must almost by definition be a mystery. Why would a billionaire buy GameStop, given what it looks like the future of that particular brick-and-mortar business is?

ERIC MCKEE: Yeah, I can't read his mind. He probably thinks he can sort of take over the company, and he's already partially taken over it. If he can continue to change the company's direction, he might be able to become the next CEO or something like that. Maybe he's trying to move that company into a totally different operating model where they do more e-commerce or something like that. That's kind of what I would want. But what his exact plans are, I'm not him.

LEE STITZEL: So he has some battle plan. Presumably he's not just throwing away his millions of dollars, right? The next question that I wanted to ask you is kind of the other side of the equation. We've talked a little bit about Reddit, we've talked about hedge funds, we've talked about shorting. I think the listener, sort of the average person that's thinking about this kind of thing, maybe doesn't have a super clear picture of what a hedge fund is or what it tries to do. “Hedge” gives us this kind of intuition that they are hedging, they kind of play it safe, and this is a good place to put your money. But we also understand that these are multi-billion-dollar operations and whatnot. So give us a sense of what a hedge fund is and what it does, what kind of strategies they employ, and how they might compare to different types of financial intermediaries.

ERIC MCKEE: Yeah. If your listeners are familiar with mutual funds, hedge funds have some similarities to them. They have investors basically buy into the fund, and that money is pooled together. The manager or managers of the fund then try to invest that and generate returns for their investors. That's what mutual funds are doing too. They're pooling together the investors. One of the big differences is that hedge funds are catering to very wealthy investors as well as financial institutions. So you have really high minimums to buy into a mutual fund, sorry, buy into a hedge fund. A million dollars is kind of the bare minimum, and usually they'll be a lot higher. So you have to have a million in cash that you want to invest in a single fund.

LEE STITZEL: So when the Reddit community gets together and says, “They're sticking it to the rich,” if you're getting a hedge fund, you sort of are getting those people.

ERIC MCKEE: Yes. You're also getting pension funds and insurance companies, where ordinary people are the ultimate beneficiaries for those companies. So it's not just the rich people who are going to be hurt by killing off a hedge fund. It's anyone who invests in it, and most big institutional investors will have at least a little bit of their portfolio in hedge funds.

LEE STITZEL: One of the few human-interest stories that I had seen in the run-up to this was somebody essentially talking about this idea. They had their own, you know, retail investor, they're doing their own thing, and they had looked and they thought, “Well, actually, GameStop needs to go down.” So they were in for a short, and of course not very much money compared to what the hedge funds are doing, but then they kind of get caught up. So there definitely is, no pun intended, collateral damage here.

ERIC MCKEE: Yes. Yes, absolutely.

LEE STITZEL: So why is a hedge fund doing things like shorting GameStop stock?

ERIC MCKEE: Hedge funds, also like mutual funds, have a really wide variety of investment strategies they choose. They're called hedge funds based on their structure, but they can do things like try to find stocks they think are going to go down and short them. They can buy long. They have a lot of different strategies, and a lot of them are hidden strategies. We don't really know what they are, but we know that there's a huge ecosystem of different strategies, just like the mutual funds.

LEE STITZEL: This is why my initial response was, why would one stock in a very diverse portfolio, like a hedge fund must necessarily be holding, how could that possibly be so damaging? And that's obviously because I didn't have this sense that a short can go terribly wrong with no limits.

ERIC MCKEE: That is a big part of why they would potentially lose so much for that. And the goal for the hedge funds, at least how they were originally intended to be, is sort of that you get returns that are not correlated with most other common investments. So you have sort of a hedge on the rest of your portfolio if you invest in the hedge fund. If your listeners know about the importance of diversification, that's kind of why the big institutional investors would want to have a small amount in hedge funds. Not because they're going to generate huge returns and make them super rich, but because those returns are not going to go down at the same time everything else goes down. That's the idea. It doesn't always work.

LEE STITZEL: All my money is in these large, diversified mutual funds. I suspect GameStop's not big enough to be in any of them, but maybe I'm wrong. I should go check and see if I can tell how much money this came...

ERIC MCKEE: Well, it depends. If you look at the prospectus of your mutual fund, it will tell you what index it's trying to track. If it's, say, tracking the S&P 500, GameStop's not in the S&P. If it's tracking the total market, it might have included GameStop.

LEE STITZEL: I think I basically have one of each of those, so we'll see. I have to go...

ERIC MCKEE: Yeah. So you might have had some exposure, because I did too, because I have index mutual funds like you do.

LEE STITZEL: Yeah. I've already said this on previous podcasts. Listeners are tired of me saying it at this point, but I have a very vanilla investing strategy, and I get big, low-cost index funds that track the whole of the market and let it do the work over a long period of time.

ERIC MCKEE: Yes, and the finance research is very much that that's kind of the optimal way to go. You can try to add more things to get more diversification, but there are sort of diminishing benefits from doing that. But if you're a really big player, like a big financial institution or a wealthy billionaire, it's worth your time to go out to the extra things like hedge funds.

LEE STITZEL: So I kind of want to think a little bit about maybe we should call them the protagonists in the story, the WallStreetBets group, and maybe even some of the individual people. I guess WallStreetBets is just a subreddit. Is there more to that story, or is it just a community of Redditors gone rogue?

ERIC MCKEE: Yeah. I don't know how familiar you are with Reddit.

LEE STITZEL: I'm quite familiar with Reddit, but not at all familiar with WallStreetBets. And I'm going to go out on a limb and guess most of my listeners have a working knowledge of Reddit.

ERIC MCKEE: Okay, so I don't have to try to explain what a subreddit is. It's kind of in the name. I think their investing strategy, if you could call it a strategy, is sort of more like gambling than what you would normally think of as investing. I manipulate my elections for my 401(k) less than once a year, probably. Okay, maybe slightly more than once. They definitely talk about trading, daily or weekly kinds of trades, which is usually not a good idea for retail investors. You usually lose a lot of money if you do that.

LEE STITZEL: So the key thing here to understand about WallStreetBets is that these are people who are used to gambling, because, I mean, it literally has “bets” in the title.

ERIC MCKEE: Yeah. They're there with more of a poker mindset and less of a long-term investment-strategy mindset.

LEE STITZEL: That is the sense I got when I was looking at the subreddit.

ERIC MCKEE: And there are other subreddits that focus more on the buy-and-hold for long periods of time because they think the stock is undervalued. You're not trying to day trade or something like that.

LEE STITZEL: I had never seen this subreddit before, but I've seen the more, I don't know if I want to call them mainstream necessarily, but the more conservative ones before, personal finance advice, those types of things.

ERIC MCKEE: That's a very nice one, yeah, personal finance.

LEE STITZEL: There's probably an entire podcast in just this kind of topic alone, how these kinds of things develop their own culture. I find that Reddit is very interesting for my hobbies and excruciating for my profession. So anything economics, you have the EconBuff stamp of disapproval on anything that has the word “economics” in the subreddit, because those are unbearable. So I don't know how the finance ones that are maybe a little more academic, I don't know what those ones are like. But the ones for my hobbies, powerlifting, chess, poker, golf, those kinds of things, those are fun and those are good, and I tend to like those. So did you have a comment about the finance ones?

ERIC MCKEE: Oh, like the personal finance Reddit? As far as I can tell, they tend to do a really good job of recommending good things for people's personal finance. There are some investing subreddits. I don't really look at those very much. I don't know if there's one for academic finance Ph.D.s. I mean, there's a subreddit for pretty much everything, so maybe there is, but it has 417 members, anyone who posts on it.

LEE STITZEL: Right. So what I was going to say about that is what's interesting about these is they develop their own culture, sort of, we might call that a subculture. And things like the personal finance one are good because, in a sense, the things that have risen to the top and become the types of things that you will always see if you go there, typically I would evaluate them as quite good advice. They're not telling you to take out a credit card to pay off your other credit card to pay off the credit card, right? They're telling you to do mostly sensible things there. I'm trying to think if I've ever seen something, and if you say something dumb, you will get shouted down, which is sort of a double-edged sword, I suppose. But you develop things that I would think are kind of in general good, but can have unintended consequences, would be the way to think about it.

A good example of this is the powerlifting subreddit, because in some sense there is a really good habit there of, if I go on there and I criticize an elite-level lifter's form, then I will be just mercilessly teased. There's some sense in which that would be well deserved, but it also has this consequence. One of the things we might like about sports is, yeah, at the end of the day I can't throw the ball as well as Aaron Rodgers, but I should be able to compare Aaron Rodgers' throwing technique with Patrick Mahomes' throwing technique, and then that be a discussion that you and I have as sports fans. And because they're so militant about not allowing people to come in there and criticize somebody who is the best at what they're doing, the casualty of that becomes this other type of discussion that, as a sport, we might like to have.

So my understanding, to bring this full circle back to the WallStreetBets stuff, is you do have kind of an odd subculture there. Can you give us a sense of that?

ERIC MCKEE: Yeah, I don't know how odd it is for Reddit, because there are a lot of kind of lowbrow subreddits. But I was looking at their subreddit the last couple weeks, and there's lots of memes and one-sentence posts that are not very interesting, or they're just literally just a meme, and then that's it. They also tend to give out financial advice, which is something that's sort of legally and ethically dangerous to do. Then they give kind of obviously fake disclaimers like, “Oh, I'm an idiot,” using more vulgar terms than that, or, “I just like this stock. Don't take my advice.” But it's kind of obvious they're not really very serious about those disclaimers.

I know the SEC is sort of investigating some of the bigger players on Reddit, and I don't know if those disclaimers would stand up in court. They might. They might be able to stand up in court. But my impression was that it was pretty obvious they really were giving financial advice, and their disclaimers are pretty weak, not convincing to me anyway.

LEE STITZEL: So there's this part of it, and this is a question that I had for later on, but I think it inserts very well in this part of the discussion: what's the regulatory fallout? What are the consequences of these things going to be? Should the SEC be going in there and pulling my Reddit account with my silly Reddit name and then prosecuting me on these things? I think you've brought up a very serious point, which is giving wanton financial advice is a somewhat serious thing. There's another part of me that says one should be careful taking any advice that you're getting from Reddit, because the point of that is not to get truth, not to get...

ERIC MCKEE: Yeah. Oh, that's a good way to put it. It's not necessarily truth. It's entertainment.

LEE STITZEL: Can you comment, I don't know if there's a way that you see that going, but just comment in general on this idea that you're going to have the SEC investigating people on Reddit for giving, air quotes, “financial advice”?

ERIC MCKEE: Yeah. I'm trying to mind-read politicians and regulators here, so I probably will be wrong, but there definitely are reports that they're investigating some of the people. There's one guy who had a huge amount in GameStop, and he was making videos on YouTube as well, where he was making his case for it.

LEE STITZEL: Keith Gill?

ERIC MCKEE: Yeah. His name was sort of exposed, so people know who he is. Probably the big reason the SEC is really interested in him is because he was originally working at a financial institution when he started that sometime last year, when he first started making those videos. So he had a financial credential and he was working at a financial company. That makes it a lot more serious than just some random person on the street telling you, “Let's talk.”

LEE STITZEL: This is a serious topic, though. I know this for a fact because anytime somebody hears that I'm an economist, the first question I get asked is, “What's the stock market going to do?” But if I get on there and I make my own personal, private account, especially if I don't advertise myself this way, but suppose that I did, I'm going to go on there and say, “You've got to trust me. Tomorrow GameStop stock is going to quadruple in value,” or something. How is that an ethical concern? How is that something that we would be worried about?

ERIC MCKEE: One of the places where you can run into legal problems here is what we call a pump-and-dump scheme, where you will talk up the stock and you're currently long, and then you sell it to the people that you're talking it up to. So it's basically just fraud, and people go to jail for that. The big financial players, if they're caught doing that, the SEC is going to throw the book at them. At best they'll have to pay a big fine. Probably more likely, whoever was actually doing it will have to go to trial and potentially go to jail.

LEE STITZEL: So one of the things that I had seen when people were talking about this is this idea: I get some notoriety, and then I start a newsletter, and I say, “Hey guys, this is going on,” and it's a stock that I already hold. Then all my listeners react to that, which inevitably, sort of a self-fulfilling prophecy, raises the stock. Then I get out before they do, and essentially I'm profiting off my own people. But it creates this vicious cycle of, “Well, I told you guys to get in the stock. Why didn't you get into it? Look, I made so much money on it.” Then everybody else is going, “But I didn't make any money on it.” “Well, it's because I didn't follow his advice fast enough.” That's the pump-and-dump kind of stuff?

ERIC MCKEE: Yeah. It can be kind of fuzzy. There are lots of people who write newsletters and make stock recommendations for a living. They do have to be careful about disclosing, “Do I have a personal position in these investments or not?” Because they would get into legal trouble if they did and they were sort of profiting off of committing fraud by lying to their customers, basically.

LEE STITZEL: Okay, so let's turn this now to the Robinhood platform. Start by telling us what Robinhood is, sort of as a broad category, and then some parts of how Robinhood functions, how they make their money, and what service they're providing.

ERIC MCKEE: Yeah. Robinhood is a discount broker. It's a new discount broker, but they basically have a similar model to, say, Fidelity, Schwab, E*TRADE, TD Ameritrade. There's a whole bunch of discount brokers, and they offer really low-cost commissions for trading. Pretty much anyone can sign up and put some money into an account and trade on the stock market. So lots of retail investors use those brokers to do their investments.

LEE STITZEL: What's this about the zero commissions, then?

ERIC MCKEE: They're kind of a new company. They sort of took advantage of the smartphone revolution, and they have an app for your smartphone. One of the things they did was they had zero-cost commissions. These discount brokers do compete for customers based on the price of how much you have to pay per trade. I know when I first opened my account, which was back a decade ago, my dad and I, because I was just like 18 or something, chose the broker based on, one, if they had a branch office close to us, and also, two, what their commission fee was. But if you have zero commission fees, well, you can't really beat zero.

LEE STITZEL: What if I pay you to come trade on my platform?

ERIC MCKEE: Well, I don't know if you could do that.

LEE STITZEL: Seems like a losing proposition for me as a discount broker, huh?

ERIC MCKEE: Yeah. So they were outcompeting all the other discount brokers, because the discount brokers were generally charging you like six, seven, eight dollars, roughly, per trade.

LEE STITZEL: Per trade? That seems like a lot.

ERIC MCKEE: Well, it used to be like 20 or 30 just a couple decades ago. My father would tell me stories about how, when he was a kid, one of his summer jobs for my grandfather was to call up the broker and order trades, and those would have cost 20, 30, 40 dollars. It was much more expensive back then.

LEE STITZEL: So that's really fascinating. There's a lot there that we could potentially unpack. You said branch location. So you're talking pre-Robinhood, smartphone-type trading.

ERIC MCKEE: Yeah, this was back in...

LEE STITZEL: And then commissions. So Robinhood has essentially solved both of those problems, and not them, but the class of people that...

ERIC MCKEE: Yeah. So I think it was last year, several discount brokers just announced one after another, “Yeah, we're going to zero-commission-fee trades.” It's basically because they were getting outcompeted by Robinhood, so they had to cut costs, or cut the price, to stay in business and compete with them.

LEE STITZEL: So how does Robinhood make money, then, if they don't charge anything for trades? It seems like that's an unsustainable business model.

ERIC MCKEE: Well, they make money a couple other ways, and all the other discount brokers tend to make money this way too. The commission fees were maybe about 25 percent of those brokerage firms' revenue. So they lost a lot of revenue, but they didn't lose everything. One thing you can do, which is probably the most controversial, is you can sell your order flow to some of the big hedge funds and high-frequency traders. Again, it's kind of controversial because you're selling that kind of information. It lets those guys profit off the retail investors. But one of the reasons they like having that information is because retail investors are collectively really bad. They make really bad decisions. So if you know they're all piling into one stock, it's probably not a stock you want to invest in.

LEE STITZEL: So this is like the opposite of the wisdom-of-crowds idea that we talk about in other places. And there's a truism in the computer-science world, or privacy concerns: if you're not paying anything, then you're the product. Is that true here?

ERIC MCKEE: That's part of their revenue. They also make money by letting their customers borrow from them. So if you are selling short, you have to pay interest to the broker, and they make a profit there. If you buy on margin, which is borrowing money to just buy the stock, again you're paying interest. Interest is really high in both cases, and they make a profit there too.

LEE STITZEL: But now if I go in there and I say I'm not going to do either of those two things, I'm not going to short, I'm not going to buy on margin, I'm just going to buy this stock and then sell this stock, buy the stock and sell that stock, just behave like what I think my listeners would consider mostly normal, in theory the only thing that I'm giving up is the privacy of my trading history.

ERIC MCKEE: Mostly. They can also take the share that you bought, because they're holding it in trust for you, and lend it out to someone. But yeah, a lot of what they would earn from you was just the order flow. So you wouldn't be their favorite customer. They want the whales who are borrowing lots and losing lots of money in the stock market.

LEE STITZEL: So that analogy to a casino circles around kind of in a distasteful way there, because the casino isn't real happy when you and I roll in with our 20 dollars, and then when we gamble 20 and it's gone, we just leave, right? They want the guy that shows up with a hundred thousand dollars ready to lose it all and then go back for more.

ERIC MCKEE: Right. That makes the brokers more money too, if there's lots of people who are treating it like gambling and borrowing and paying lots of interest.

LEE STITZEL: Yeah. So the last thing, before we sort of turn to the outcomes, I guess, as far as we know them so far, is this idea of a clearinghouse. The episode that I just recorded, we talked about why Robinhood went and shut down trading, and we sort of explored all the different ways that this might have happened and why, and the motivations, what we call narrative economics, right? But one of the things that comes up in there is this kind of mechanical explanation: Robinhood is essentially forced into doing what they did, which is cap the buying and allow the selling.

ERIC MCKEE: Yeah.

LEE STITZEL: Which looks really suspicious.

ERIC MCKEE: It does, yes.

LEE STITZEL: Which I would love to get your opinion on. But before you go there, tell us how that mechanical part would work. What's a clearinghouse, and how is that involved in this?

ERIC MCKEE: Okay. So when you do a transaction, you buy a share of stock, there has to be a legal transfer of ownership of the share from the seller to you, and that takes a couple days. Generally, in finance, that's called settling the trade. So if you sold your share of stock, the cash will show up in your account, but usually the broker will say, “Well, you can't withdraw it yet because we haven't got the cash from the trade. It hasn't been settled.” Or they sometimes will let you buy something new with it because they will put their own cash in and then sort of make good after a couple days. But the trade isn't fully complete yet.

The clearinghouse is sort of a third party who would take collateral from both parties and act as a mediator. Once the trade clears, they'll send the appropriate amount, cash or stock, over to the right person. So it's a little bit like, say, an escrow account for your mortgage. You put some money in there, you're required to do that, and then they release it to the right person after the documents are signed or things like that. Because there's some lack of trust between the parties, you have a third party to handle that.

LEE STITZEL: So this is like, I mean, we would understand this if we've ever bought or sold a car or house or something like that.

ERIC MCKEE: Yeah, because I bought a house when I moved here just this year, so it was very fresh in my mind because we had to use an escrow account.

LEE STITZEL: So it is that same type of idea, sort of.

ERIC MCKEE: Yes.

LEE STITZEL: And so I think one of the things that accompanies this question is: why do we have to do this for our online trading? Which I think you've already essentially answered. But I think people have this idea of money that's being traded hands digitally, or things that are being kept track of digitally, is somehow less real than if I had to walk over a hundred-dollar bill and you had to hand me a piece of paper.

ERIC MCKEE: Yeah. Emotionally, it definitely seems different. It feels painful for me, at least, to have to, even if I take the credit card out, it feels painful for me. I'm kind of a weird, super-frugal person like that. But taking out the cash or having to hand over the check does make it feel more real. There is an actual transaction going on, and there are legal requirements. You have to transfer ownership, and that does take some time. Maybe it could be made faster and more efficient. That's something I'm not really an expert on, if you can do that. But what we have right now is what we have right now.

LEE STITZEL: One of the things that personal-finance people will advise you, right, is you make the budget, and then you transfer the money that you're going to have for eating out into an envelope, and you carry the money around because it gives this increased psychological barrier to hand over money than it is to swipe it on the credit card.

ERIC MCKEE: Yeah, that's kind of a behavioral-finance sort of thinking.

LEE STITZEL: Do you think that still holds? I'm getting way off. For investing, or just for personal finance?

ERIC MCKEE: For personal finance, behaviorally, it seems to work. It probably doesn't work for everyone. Some people, it probably doesn't feel any different. But if, on average, or even just a large minority do, then it's probably good advice to give people.

LEE STITZEL: So you and I are roughly similar age, right? I'm about to be 32 here in a couple weeks. You're a little younger than I am. I have never really developed that. So when I've tried that type of strategy for budgeting before, I wouldn't describe myself as super frugal, but I'm not one of these free spenders that has to rein in his budget. I kind of have money for this and have money for that, and that's how I do it. But I never established that personal psychological thing where, if I've got money in an envelope, that's because it's meant to be spent. So I never got the psychological pain. It's almost worse. I might go through the cash quicker because my brain is like, “This is for spending.” But the card is attached to my actual bank account, and that's where the money I need to keep is also kept, right? So I'm going to be more careful with that.

Now, maybe I could just be weird, but it's the fact that you brought up this idea that actually having to take your credit card out causes you more psychological distress than maybe clicking buttons on an app would. Can you comment on that?

ERIC MCKEE: I mean, me personally, it's not that I really use those kinds of behavioral-finance strategies. It's just that I don't have very expensive hobbies. I don't go out drinking ever because I don't like the taste of alcohol. So that saved me a lot of money over the years. It's just sort of your personality, how you were raised by your parents. My parents were very frugal. They passed it on to their children. So yeah, I'm not sure where else you were going with that.

LEE STITZEL: No, I was just sort of in general commenting on that, and the listeners at home, when you hear this, you can get in the comment section there and tell us whether it's more painful for you to pay with credit card or with cash. So it's always good to have cheap hobbies. I took up golf this past summer for sort of obvious reasons, because it's an outdoor sport that you can do and be far away from people. Not that I'm particularly militant about such things. It just happened to be expedient. That's not an inexpensive hobby, though.

ERIC MCKEE: So yeah, if you're going to stay away from alcohol, stay away from golf too, I guess.

LEE STITZEL: Okay. Do you have more to add to this idea about why Robinhood would stop trading on GameStop and some of the other stocks, or do you really think it is that clearinghouse-and-collateral example?

ERIC MCKEE: So there's kind of a conspiracy theory that subreddit was saying, thinking that Citadel, who is one of the high-frequency traders that buys order flow, they're an investor in Robinhood, that they also have a small stake in one of the big hedge funds...

LEE STITZEL: Is it Melvin?

ERIC MCKEE: Melvin, yeah. So they were putting pressure on Robinhood, and I guess all the other discount brokers, because all of them were doing the same thing. I don't think that's really true. I think it's because of this clearinghouse. Normally you would put up a really small fraction of the actual cash value of those shares. But because of how risky things were, the clearinghouse is like, “Oh, we need to have more collateral here because it's much more likely that one side of the trade is going to be unable to fulfill their promise that they're going to deliver.”

And actually, another thing to add there is, if you have your customers buying and also selling, they'll sort of net out. So you can kind of not have to worry so much about the clearinghouse. But if everyone on your app is all buying and not selling, then you're going to have a really unbalanced need for cash.

LEE STITZEL: That's really an interesting observation. That's probably one of the reasons they would restrict buying, because they have to put up cash then. But they're okay with you selling because everyone's trying to buy, so they're not too worried about the collateral in that case. So the fact that it looks bad, that they cap the buying but allow the selling, also has a mechanical explanation.

ERIC MCKEE: Yes.

LEE STITZEL: Okay. Yeah, I love it.

ERIC MCKEE: And we know they raised tons of cash. I think my personal impression was that they were probably really close to bankruptcy, and if they hadn't done the financial-company equivalent of pulling up their couches and digging around for quarters, they would have gone bust.

LEE STITZEL: Interesting. So we've already kind of mentioned the pandemic in some of these different senses, but one of the reasons, when you and I were talking about putting this episode together, one of the things you were interested in talking about is the role of the pandemic here and the accompanying stimulus checks. Does this episode happen if we saw all the same conditions except those two things, but in 2019, say?

ERIC MCKEE: I think the zero commissions, making it free to trade, played a role too, making it really easy for the retail investors to pile into whatever stock they want. So that's probably a big part of how this is able to happen. But yeah, the pandemic, people are sitting at home. Another thing is that there are lots of people who bet on sports, and those sports events are not happening, or it's a lot harder to go to the bar and place a bet on your favorite team. Well, you can bet on the stock market too, and if you have zero commissions, it's a lot cheaper.

And there's a lot of stimulus too. Actually, if you look at personal income, normally in a recession it goes down, but it actually went up during the recession. I assume, I think, that's because there were unemployment subsidies and just the straight checks from the federal government. So you have lots of cash, you have lots of time on your hands, you can't bet on sports anymore, and it's free to trade on the stock market. That's all sort of combined.

There's actually a guy who was the founder of an online sports-betting website, Dave Portnoy, I think.

LEE STITZEL: Portnoy, yeah.

ERIC MCKEE: Portnoy, yes. And he's just basically doing the same sort of betting thing, but with the stock market. He's making social-media videos and stuff, talking about, oh yeah, he's piling into, I think he's AMC now, because he lost a lot of money at GameStop.

LEE STITZEL: That's kind of scary in some ways. I guess far be it for me to judge other people's actions in this kind of context, but that doesn't fill me with a lot of confidence.

ERIC MCKEE: Yeah. There are financial writers that I follow who think this zero-commission thing was really, really bad for the market as a whole, because the role for the market is to have a price that accurately reflects how well the company is going to be using capital and growing people's wealth. And so if we make it too easy for people to just pile in and out, that price becomes less useful for us in terms of allocating capital.

LEE STITZEL: Okay. So what I'm interested in now is something that I touched on earlier. It was this idea that the Melvin hedge fund could somehow lose, I think, four billion dollars when I last looked. Maybe you've looked since I looked. How is it possible that a hedge fund loses four billion dollars on a short squeeze of a stupid stock like GameStop, which is in the whatever, six- or seven-buck range when this all took off?

ERIC MCKEE: The only reason they can lose that much is because it's an unlimited loss. Otherwise, they would not have been able to lose that much money. But if you do some quick mental math, or back-of-the-envelope calculations, let's assume they had ten million shares sold short, which is a lot, but there were about 50-plus million shares sold short, and we know they had a big position. So it's not impossible that they were that heavily short.

Let's further assume that they sold in at ten dollars a share and they got out at 310. So they lost 300 per share. They had ten million shares. That's three billion right there.

LEE STITZEL: Oh, wow.

ERIC MCKEE: And they might have gotten in at a lower price, because I think the lowest price was like $2.50 in the past year for GameStop, and the price did spike to above 400. So we could make it even worse and get it up to like four billion just from those losses alone.

LEE STITZEL: So just by scale, the math checks out.

ERIC MCKEE: Right. Yeah, you can get up into the billions if they covered at the highest price and they sold in at the low price. Normally, hedge-fund professional traders are going to have risk limits, and they'll be forced by their risk-management team to close out their position when it starts moving against them. Maybe GameStop just spiked so fast that they couldn't do it entirely. There are also a couple other ways that they probably lost money too. They were selling short. They were probably short for a number of months. I remember when I was teaching my investments class in the fall, I was teaching about short selling. I looked up who was most heavily shorted. GameStop was number one. This was back in October, September, something like that.

ERIC MCKEE: So they've been heavily shorted for a while now, and you have to pay interest. It's a pretty risky loan, so your interest rates are really high, credit-card-interest-rate high. There's a big carrying cost for the short sellers. And then, assuming that they were putting in cash to have extra collateral, the hedge fund is not going to have billions of dollars of cash just sitting in their bank account. They have it invested in other places. So they had to sell those things. They had to sell them really fast, usually at a bad price if you do that. So they probably took some big losses with all their other investments because they had to sell real fast.

I don't know if they include that in how much they lost. Maybe they do, maybe they don't. But that probably adds hundreds of millions, maybe a billion. It might add a billion or more, potentially, depending on how bad it was for them.

LEE STITZEL: Okay. So I heard some news that was talking about, and I think it might have been Citadel, but there was another firm that sort of came, and “bailout” isn't really the right word, but put some money in.

ERIC MCKEE: Oh yeah, I think that was Citadel.

LEE STITZEL: It was? Okay. They invested some, like, a billion or two into the hedge fund.

ERIC MCKEE: Yeah. That's probably because the hedge fund was really struggling to have enough cash to cover their short position.

LEE STITZEL: But that's some kind of signal too that they think, well, it's not that Melvin did something wrong and they were doing something dumb and then they got caught. They're thinking this is like a once-in-a-century kind of event and it's not likely to happen to Melvin again, or...?

ERIC MCKEE: Probably. Everyone's pretty confident that the stock price of GME is going to come back down. So if you can get in when it's at 300 a share and you think it's going to drop to 20, 30, whatever, there's a big profit potentially there from going short. And I'm sure that Citadel had some very generous concessions from the hedge fund that they gave the money to.

LEE STITZEL: Yeah. It's not charity.

ERIC MCKEE: It's not charity. The pros on Wall Street are ruthless, and they'll happily take advantage of the retail guys, but probably take advantage of each other too if they can.

LEE STITZEL: So this is that kind of classic, every Wall Street movie you've ever seen, they always talk about sharks, right?

ERIC MCKEE: Oh yeah.

LEE STITZEL: So there's blood in the water.

ERIC MCKEE: Oh yeah, definitely. There was definitely blood in the water for the hedge funds that were initially short.

LEE STITZEL: Yeah. I had this notion, and I think about these kinds of things sometimes. I have some other ideas about what I would do if I sort of had a set of money that I would like to do my own things with, not my retirement money, but money I would be okay with losing in order to kind of, maybe you could give me “gamble,” but just sort of play with this kind of thing, because it's interesting and a lot of people find it interesting. So I had that thought go across my mind that was like, it's not for somebody like me, but it's probably pretty smart to go buy a short option now when it's four hundred dollars, right?

ERIC MCKEE: So I have a small account where I do that, where I make trades. I don't day trade. I usually say, “I think this company is undervalued,” and then buy it and expect to hold it for years on end. But I saw that and I was like, “Hey, it's going to have to come down. I'm going to buy what's called a put option on GameStop.”

LEE STITZEL: So what's different from the put option and a short?

ERIC MCKEE: A put is, you have the right to sell at a certain price, and a call option is, you have the right to buy at a certain price. So if you buy a put, first of all, your loss is only the amount you paid for it. You can't lose more. And if the price goes down below that strike price, then you can sell it for higher than what it's currently worth, and you can basically pocket the difference.

So I'll see if my put actually works. It expires on Friday, and if GameStop continues to go down a lot the next day, I might actually make money. Otherwise I'll probably lose money. But that was just a small amount of that total account. I was like, “Okay, I'm willing to risk a couple hundred dollars on this. If I lose it, it's okay.”

LEE STITZEL: Yeah. But if you're betting your entire portfolio on that, that's very risky and probably not going to end up well for you. My suspicion is we're going to hear that type of story come out of this a week or two weeks or a month from now, and Joe Investor is going to have lost a hundred thousand dollars out of his children's college fund because he's buying shorts, or he's buying GameStop and didn't get out soon enough, or something.

ERIC MCKEE: Yeah, there's probably variations of that story.

LEE STITZEL: Comment on that and the retail investors and their general badness at investing.

ERIC MCKEE: Yeah. When I was looking at the WallStreetBets subreddit, I did see a couple of people who were saying, like, I think one person was using their student loans to buy. I was like, “Oh my gosh, this is going to end horribly for this person.” Also, you probably committed fraud, because your loan probably says you're supposed to spend it only on your college expenses, not on trading in the stock market.

But yeah, that does tend to happen when they have a big bubble or something like that where retail investors pile in. They invest too much, or they borrow, which is generally even worse than just buying with your own cash, and then they get burned. It's really sad and awful when it happens. That's actually kind of the impetus for a lot of the financial regulation, to try to prevent that from happening. So retail investors aren't allowed to invest with hedge funds, both because the hedge funds don't want to deal with small sums like that, but also because hedge funds can blow themselves up like that, and you don't want grandma's retirement account to go to zero because she made a really bad decision there.

LEE STITZEL: So let's talk a little bit about, and I hope I've got the name right, but the person that we had talked about earlier, the Gill character. I had read something this past Friday that said something to the effect of they were in for 45,000, and then it was up to a million, and then I'd been updated as this week went on that just somehow got to like 45 million dollars. Now, that's in the value that they're holding the GameStop in, right? So they need to sell in order to actually realize that at some point, right?

ERIC MCKEE: Right.

LEE STITZEL: Talk to us a little bit about that process, and whether that individual seems ready to basically just be content knowing that he cost Melvin four billion, or is he actually trying to make himself a lot of money?

ERIC MCKEE: So that guy was actually posting every day his amount, or a screenshot. It could have been a doctored screenshot, so you don't know for sure that's really his amount. But yeah, he had both bought stock and also bought calls, according to those screenshots. Some of those calls had expired in the money over time, so he actually had a huge amount of cash too. I don't know if he bought more GameStop or not. But at some point, if you're in a short squeeze like that, you have to sell, and you want to sell before everyone else starts selling and starts bringing the price back down. Timing that is just so hard, and pretty much no one is able to reliably pull that off.

LEE STITZEL: Yeah. So we'll be looking for that story to come out next week or the week after, and I'll eagerly read to see what he seems to have.

ERIC MCKEE: Yeah. If he really did have calls that expired and he got cash for them, and he kept that cash, then he'll have made millions of dollars from this event. But most people, if they bought and then didn't sell when it was high, probably ended up losing quite a bit.

LEE STITZEL: And I think there is some of that, where it was six or seven bucks, and then somebody sees it go up to 200 and then they buy. Then they see it go up to 400 and they think, “Man, I'm really killing this. It's got to go up to 600, 800, a thousand.”

ERIC MCKEE: Yeah.

LEE STITZEL: But 400 was the high, and then it turns around and drops back down. Hopefully they get back out before it's 200. But in some sense, at that point somebody's losing here, right?

ERIC MCKEE: Yes. Yeah. So the reason they were so confident on that subreddit, anyways, was that they're buying, they're sort of kind of cornering the market, because there's no one available for the shorts to buy from besides them. And then they can sort of just name their price. It's kind of like they're playing a game of chicken with the hedge fund, except they're all different people. It's not just one person competing with the hedge fund. So that's a disadvantage for them, because if a couple people break ranks and decide, “I'm going to cash out now,” then the whole thing can collapse.

But on the other hand, the hedge fund has to pay interest. So they have someone sitting in the passenger seat, maybe, who can reach over and sort of grab the steering wheel, because their lender wants them to pull out and avoid the lender getting into that car wreck.

LEE STITZEL: I'm glad you brought that up, because that really highlights this idea, right? They're trying to corner the market, but they're all colluding, and the higher the price of that stock goes, the higher the incentive to cheat, if we were to use the economic theory.

ERIC MCKEE: Exactly.

LEE STITZEL: And so that deviation, or you called it breaking ranks, becomes a higher and higher incentive until eventually it comes crashing down. So the people who are in it most to stick it to the hedge fund and not make money for themselves, the most pure amongst them, I guess, they're the ones that end up holding the bag and losing the money.

ERIC MCKEE: Yeah. But it's sort of interesting because if you're a first mover, suppose that I bought it at six or seven bucks, and it goes all the way up, it comes all the way back down, and then it's there at six or seven bucks...

LEE STITZEL: Right. I guess I didn't lose anything.

ERIC MCKEE: You didn't lose anything, but probably psychologically you took a big hit, because those big price swings can really affect you. I know with my small short position, it was too much risk for me. I should have put in less, because I was just constantly looking at the GameStop price, and I really needed to get work done.

LEE STITZEL: This is your behavioral finance coming back around again. When you buy stocks, or you buy put options, or you buy shorts, or something, buy enough that if you forget to check for a day, you don't panic.

ERIC MCKEE: Yeah.

LEE STITZEL: Okay, so there you go. Definitely, we've learned two things.

ERIC MCKEE: Yeah. And another point about market regulations: that sort of collusion to corner the market would be illegal. If a hedge fund tried to do that, they'd be facing legal consequences. There are some examples in history of people that tried to do that. There's a famous incident back in the '80s. The Hunt brothers tried to corner the silver market. They ended up losing their fortune and going to jail for that. So again, they're making all these disclaimers about how it's not really advice, but if there's a wink and a nod that comes out, that could be dangerous for them legally.

LEE STITZEL: Okay. So I want to finish up with a couple of little questions here. We've talked a lot about the collateral and why that had to happen, so I think we've covered that. But another question that got asked to me is: how can there have been so many stocks of GameStop going around when it seems like there should have been a set number of them? So explore this idea of there having been, I think, 120 percent of GameStop stock being shorted. That seems like that should be impossible to the observer. So explain, right, back-of-the-envelope math to us.

ERIC MCKEE: So first, how we know about the short selling: the short selling gets reported twice a month. So if you see the short-selling data, it's probably a week or two old and out of date, but it is actual data. The financial firms are required by regulation to report the short position, and that gets aggregated to the company level and then released to the public.

Now, the reason it was over 100 percent is because it was being compared to the float, which is something less than the total shares outstanding. There are some people, like probably the Ryan Cohen guy who bought into the company, whose shares are sort of held, locked up. They're not going to be traded. And so the float is kind of our estimate of how many shares are available to freely trade on the market. There are insiders who are not allowed to trade because of insider-trading rules. Their shares would not be included in the float.

Now, the other reason you can have so many shares being sold short is that, say I borrow a share from you and then I sell short. Well, the person I sold it to can also lend it out to another person and have that same share sold short again, and you can keep doing that over and over again. So shares can be sold short more than one time, and that just sort of creates a liability where you have to go and buy. So if that person that I sold it to, that position has to close out, one person out there has to buy, and then I have to buy as well. I can buy the same share or a different share depending on who is selling it to me. So it's possible, in theory, for you to sell shares short basically for an infinite amount, pretty much.

LEE STITZEL: Okay. So we're over an hour now, so I want to bring this in for a landing. The way that I want to do it is to take a question that was sort of general and was asked to me by a listener, a question that I liked quite a lot. But I want you to take it more of a philosophical direction. The question is: how can this type of episode happen, and why does that seem to violate the things that we've learned about finance?

From a technical perspective, you've essentially surrounded that question. So hopefully that listener is listening to this saying, okay, now that I'm seeing it all laid out by an expert and I can sort of walk through the path, yes, it's complex and it's kind of weird at the same time because this isn't a traditional story. But hopefully, I think at this point, that type of question is saying, “Wait, why does what I seem to have learned in my finance class not apply?” I think we've annihilated that question. You've done a great job at that. So take us in a little bit of a philosophical direction and comment generally on how the finance classes, or finance education, finance things that we're taking, and how we apply those to these specific situations, and just kind of a general comment about the philosophy of finance.

ERIC MCKEE: Sure. Yeah. So I think your listener was probably thinking of the efficient-market hypothesis and how the prices should always sort of accurately reflect the true value. Well, first of all, that's a hypothesis. We haven't really proven that. I think there are some good papers that kind of say that you can't prove that hypothesis, period.

But in terms of market efficiency, we sometimes will simplify it in class and say, well, there are a couple different versions of market efficiency, and we think the stock market is efficient. In practice, how efficient it is, is more of a spectrum. The more people you have trading, the more volume of trades you have going on, the easier it is for that price to really converge on the right value, and the harder it is for some weird technical thing like this to cause the price to go in crazy directions.

Actually, GameStop is a pretty small stock. It was well below one billion in market cap, which sounds like that's actually big, but compared to something like Apple, which has over two trillion in market cap right now, it's really a pretty small stock. And we do tend to see that when we have a small market, efficiency is harder to get. There's more friction in terms of getting the price to match the true value, and it's easier for some weird event like this to spike things in the wrong direction. Eventually the market will come back to the right price, but it might take longer than it would in a more robust market.

LEE STITZEL: I tried to promise you that I wouldn't interject when we got to this part of the episode, so I'm going to go back on my word there. The reason is this: I'm glad you took this in the efficient-market-hypothesis direction, because one of the things I was just teaching in my micro class is this idea that markets are actually better understood as a process. The consequence of that, and this is probably a whole other topic for a whole other episode, but the long and the short of that, no pun intended here, is that a snapshot of a market at any one time really doesn't tell us very much about the efficiency of the market, because the market is a process.

So all these steps that we're seeing, the actions and the reactions and the back-and-forth of this, are part of how the market process irons itself out. And I think that works just as well for financial markets as it does for markets in general. So comment on that really briefly, and then we'll close it out.

ERIC MCKEE: Yeah. One of the things we talk about with market efficiency is how quickly the market corrects to the right price, how fast it responds. So how quickly does GameStop go back to the kind of right-ish price? That's one of the ways we talk about how efficient the market is. So the fact that it's coming back down, right now it's around 60 or something a share, so it's come down quite a bit from that spike, is kind of a sign that these things are fairly efficient. It's only taking a week or two before we go back to normal.

And there was sort of a real, legitimate reason for the price to go that high. There were people that had to buy. It wasn't because of the fundamental valuation, but there really was buying pressure from buyers that pushed the stock price up. So the normal supply and demand was still kind of working. It just didn't match the fundamental valuation.

LEE STITZEL: My guest today has been Eric McKee. Eric, thanks for joining us on EconBuff.

ERIC MCKEE: Yes, thank you, Lee. Very good conversation.

LEE STITZEL: Thank you for listening to this episode of the EconBuff. You can find all previous episodes on YouTube at EconBuff Podcast. You can check out our website at econbuffpodcast.wixsite.com/mysite. You can contact us at econbuffpodcast@yahoo.com.