Feb 03

Is there a scenario where Redditors don’t get hurt?

This blog post was written by the Bryan School’s Dr. Vasyl Taras, Associate Professor in the Department of Management.

Reddit users decided that Wall Street’s bet against GameStop is immoral and greedy. I am not sure why shorting is immoral and greedy, but OK. So, the Redditors start buying GameStop shares, and as demand increases, the price goes up. Economics 101. As the price starts going up, Reddit users smell victory and continue pouring money into the GameStop stock.

It’s a fun game, and it looks like they’re making money. But what’s the exit strategy?

Emboldened by the GameStop success, it appeared this week that Redditors were buying silver. This time, I was not sure who was being punished for their immorality and greed. My kid, who’s following the developments closely and has apparently bought some GameStop shares, suggested users seemed puzzled by the jump in silver on a sub-Reddit forum. It was apparently falsely attributed to them.

But as of now, millions are tied up in shares with an artificially-inflated price. Reddit users can’t pull out the money because once they start selling their shares, the price will plummet. Even if they just stop buying, as new demand dwindles, the price will drop.

So, what’s the plan? And how is it different from a Ponzi scheme? Here are some viable explanations and strategies I see:

1. Reddit users only jumpstart the buying frenzy

As the price starts skyrocketing, Wall Street jumps on the bandwagon to get a piece of the action. Smart Redditors exit early and watch from aside as Wall Street continues making their speculative bets. Eventually, the pyramid collapses, Wall Street loses, and Redditors don’t lose because they exited in time. Maybe Reddit users even short the GameStop stock while the price is at its peak. So far, though, it seems it’s mostly Reddit users’ money, while it is Wall Street that is shorting the stock in anticipation of a massive crash.

2. The possibility of one scheming Reddit user

Is it possible that this is not a collective action against a greedy and immoral Wall Street, but a particular individual’s ploy to scam naïve Reddit users?

In this scenario someone buys a bunch of GameStop shares on the low, rallies up a group of Reddit users into action, those users pour money into the stock and inflate the price, and the original mastermind sells the stock at its peak. Those who joined early and sold fast get their money back and then some. Those who joined late and were slow to leave lose big time, which would be the usual Ponzi scheme math.

3. Is there another possible outcome where Redditors don’t get hurt?

Let’s back it up a few steps. Say GameStop shares trade at $15. A hedge fund thinks that the price will fall to, say, $5 — so the fund shorts them. That is, borrow GameStop shares, sell them at $15, promise to return them, say on Feb. 1, hoping that by Feb. 1 the price will drop to $5 and the hedge fund will be able to buy them at $5 and pocket the $10 difference.

Redditors start buying GameStop shares and thereby inflate its price to $300. Feb. 1 comes, the hedge fund must return the shares and, therefore, must buy them at $300. So the hedge fund shells out the money to buy those shares, possibly pushing prices even higher, and loses money when returning the shares.

At that point, the Reddit users sell their shares, possibly to the hedge fund itself, and exit with a profit. Some Reddit users are too late and must sell after the price crashes, but most get their money back, and after the dust settles we’ve seen a transfer of money from the hedge fund to the Reddit users.

This, whether the original plan or not, is plausible. But it’s still likely that many Reddit users get burnt along the way, even if some make a handsome profit.