UMACRJ-15-M: Equity, Bonds & Derivatives

GameStop Saga: Perspective from Rational Finance & Behavioral Finance Theory

Student Name: Musaddiq Jawaid

Program: Msc in Finance and Investment

Student ID: 21063988

Total Word Count: 2510

Main Body: 2000

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Table Of Contents Page No.
1. Introduction………………………………………………………………………………3
2. The GameStop Episode………………………………………………………………..4
a. An opportunity to short-squeeze created by hedge funds
b. A tweet that fueled the hype
c. The aftermath
3. The investor’s approach to GameStop: in light of financial theories………………4
4. Impact of Social media on Stock Pricing……………………………………………..5
5. Impact of Noise Trading on Stock Pricing……………………………………………6
6. Impact of Short-Selling on Stock Pricing……………………………………………..6
7. Conclusion……………………………………………………………………………….7
8. References………………………………………………………………………………8

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1. Introduction:
(De Long et al., 1990) recognized that how stock prices are deviated from their
fundamental value by noise traders’ sentiments. There has been a significant revamp of
information and communication technologies characterized by incredible mounting of
social media platform which allows us to disseminate massive news and information at
an incredible speed amidst surging users. Therefore, these platforms have a significant
influence upon financial markets which can be well elaborated with the recent
GameStop episode.
The incident of GameStop (GME) has captured the attention of global financial
community when its stock price skyrocketed from $16 to $450 within a short span of one
month during January 2021. An interesting chapter that unfolded from this incident was
the anomaly of stock prices in relation to its true value. Thus, this episode provides a
unique case of the impact of investor sentiments, social media and short selling on
share prices.
The episode of GameStop begun when the Wallstreetbets (WSB) group of Reddit
Platform, that comprised of a large number of retail/small investors, planned a mob
against the institutional investors, mainly hedge funds, to prove supremacy of crowd
against the institutions that had massive short selling positions of GameStop. This was
done by taking long positions in GME against the short selling position of hedge funds.
Although, the decision of hedge funds to go short on GME was primarily from the
perspective of its weakening fundamentals that was being signaled by company’s
performance since last three years.
However, amid the weak fundamentals, the small investors from the WSB group went
long on GameStop shares that led to a 21-foldincrease within the span of just one
month wreaking huge on the institutional investors. It was highlighted by (Chung,2021),
one of the biggest US hedge funds, Melvin Capital Management, suffered a loss of 53%
of its investments in January 2021.

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2. The GameStop Saga

2.1. An opportunity to short-squeeze created by hedge funds

In the episode of the GameStop’s (GME) saga, institutional investors decided to take
short position of the stock believing that firm was ailing to adapt new strategies to cope
with the digitalization of gaming amid lockdown chaos. Hence, there was an excessive
shorting position of Institutional Investors signaled the declining prospect of GME stock
price to the market sentiments. Approximately, GME’s stock were sold short by 140%
during 22 January 2021, where two major funds, Citron Research and Melvin Capital,
took an aggressive position of the short. By 27Janaury, the anticipation of these
institutional investors got struck hard when increased interest from small investors
resulted in 700% hike in the stock price. (Thorbecke, 2021)
2.2. A tweet that fueled the hype
On January 26, Elon Musk tweeted a link to Reddit/WallStreetBets that bolstered the
confidence of reddit users to take long positions on GME. As a result, there was more
than 90% rise in its stock price that resulted GME to become a larger listing on the S&P
500 index with into a market capitalization of USD 33.7 Billions. In turn of this short-
squeezing, the hedge fund Melvin Capital, lost 30% of its value year-to-date and bared
USD 2.75 billion loss prior to its closure of the position on January 26. Whereas, Citron
witnessed a 100% loss when it closed the position. By January 27, GME’s stock price
surged over 1500% from the levels of preceding two weeks. (Thorbecke, 2021)
2.3. The aftermath
The fueling hype of the small investors suffered a major halt on January 28, 2021.
During the pre-market session the GME stock opened even higher from the previous
session where it hovered around $500 but in turn of events it dipped to low as $300.
Robinhood’s trading platform, just by the timing of trading session to commence on the
bourse, delisted GME and some other stocks and created a restriction on integrating of
further new position in these stocks. (Thorbecke, 2021)

3. The investor’s approach to GameStop: in light of financial theories

When it comes to explaining the individual’s attitude towards investing, two theories
come into limelight; Traditional Finance Theory (Rational) and Behavioral Finance
(Irrational). In order to identify the investing bias of the individual investors as well as the
institutional investors in the episode of GameStop, it is essential to look through the lens
of these theories. To recap, numerous economic and financial theories ascertains that
the market participants are rational and their investment decision making are based
upon all the information available. The current accepted theories formulated by
(Markowitz, 1952), (Fama, 1965), (Jensen and Meckling, 1976) shares a common belief
of investors rationalism and advocates efficient market hypothesis (EMH). To explain,
EMH states the principle that security price reflects all information available and thus it
is fairly valued. However, when these traditional theories failed to explain stock price
volatility the foundation of behavioral finance was laid. Some prominent scholars
including (Grossman and Stiglitz, 1980), (Malkiel, 1995), (Carhart, 1997), (Hirshleifer

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and Shumway, 2003) identified that the decision making of an investor is derived from
emotions and psychological bias. To explain the decision bias of investors, researchers
try to explain the attitude of investors with the notion of cognitive bias that was
introduced by (Tversky and Kahneman, 1974). Apparently in the episode of GameStop,
investors were influenced by their forum participant that eventually bolstered their
overconfidence and amplified the herd mentality. Also, fellow members on
WallStreetBets have urged and encouraged each other to buy and hold, and have
created their own lingo and culture reinforcing the sense of community fighting against a
common enemy. It also underpinned the psychological idea of loss aversion or sunk
cost fallacy, where people continue to pursue a loss-making course even if it is not
sustainable as they have already committed a significant amount to it.

4. Impact of social media on Stock Pricing

Social media, that was once considered to be a socializing platform, has become a
powerful to drive market sentiments. One of the foremost aids of the social media
transformation could be a more extensive access to the data accessible to all sorts of
speculators counting both retail and organization speculators (Chen et al., 2014)
contends that ample of resources are available to institutional investors, however
retail/small investors can gain an access to market information through social media
platforms.
(Behrendt and Schmidt, 2018) argues that the stock price reflects the trading activity of
both institutional and retail investor. Whereas, (Boehmer and Kelley, 2009) widely
claims institutional investors to be well informed and rational. On the contrary, (Black,
1986) suggests that the retail investors are irrational because their investment decision
are driven by various psychological biases. Therefore, if the sentiments of retails
investors are affluence from social media platform, then the stock price would be
determined basing on their beliefs and can rather than fundamental values and thus will
be inefficiently priced.
Although, social media tends to keep people engaged for limited span of time, but even
then, it is more susceptible to bolster overconfidence because most of the peers tend to
share post about their wins rather than losses, especially when there is an overreliance
on influencers or group member. It is general practice for the people on social media to
only post about their wins and not losses, which can strengthen overconfidence and
amplify the herd mentality. Also, when a community member sees peer making profit
from stock trade it is possible to have persuasive effect individual’s decision making -
this could also intensify the “Fear of Missing Out”.
A crucial role in the GameStop was played by social media platforms where the Reddit
Group participant kept purchasing the shares pushing GME stock prices higher and
effectively squeezing short sellers. Later on, investors sentiments were further fueled by
activity on other platforms. Notably, the prices GME soared another 45% in after-hours
trading after Tesla CEO Elon Musk tweeted about it along with a link to the
WallStreetBets subreddit.

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5. Impact of Noise Trading on Stock Pricing
A noise trader is considered as an individual who executes trade based on incomplete
or inaccurate information. The trades made by a noise trader is often influenced by
rumors, rather than on solid-technical or fundamental analysis, resulting in deviation of
prices from its true or fundamental value. Explicitly, it was witnessed in the episode of
the GameStop saga that there was an extravagant boost in the trade volumes of GME
and surge in prices when the rumors related to it being “undervalued” surfaced on the
internet. As per the findings of (Black, 1986), noise trading is considered beneficial
because of the liquidity it provides to the market as seen in the case of GameStop
where the volume of trade increased substantially.
Whereas, the impact of noise trading on stock prices are concerned, (Fama 1970)
theory claims that the market prices are a true reflection of information available and
thus arbitrageurs can offset the position of noise traders bringing prices to their fair
value. On the other hand, by (De Long et al., 1990), (Shleifer and Vishny, 1997)
recognized noise traders as the basis for the limits of arbitrage, quarreling that noise
trading parades risks that hamper arbitrageurs and prevents prices from returning to
fundamental asset values which was clearly witnessed in the skyrocketing session of
GME prices.

6. Impact of Short-Selling on Stock Pricing

Another factor which has played a crucial role in the churning incident of GameStop is
the level of short sale activity. The enormous short selling caused an overloaded
position on the short side, which, hence, was characteristically defenseless from a
potential reversal. (Cohen, Diether and Malloy, 2007) concluded that one of the notable
parameters to anticipate stock volatility is to analyses the volume of short selling. The
investors belonging to the Reddit group, numerous of which were not amateurs,
appropriately noticed this opportunity and prospered in imposing a squeeze on hedge
funds who were betting on the prices of GME stock to decline. At this point it is
important to note that the short selling arguments and the respective academic works
are not new. For instance, the correlation between the shorting activities with the prices
was further endorsed by (Boehmer and Kelley, 2009). The “Capital Constraint” theory
also explains the phenomenon in detail where it is emphasized that the significant
concentration of short sellers nearing their breakeven point are more prone to losses
that would unwind from short-squeeze.

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Conclusion:
In line with the rational theory of finance, the Institutional investors took short position in
GME with a rational anticipation of decline in the stock price because of the ailing
indicators and information pertaining to the company that was publicly available.
Therefore, it is apparent that investing style of institutional investors was from the
rational perspective. It is important to note that the investment decision was not tempted
by the social media affluence that was already surfacing on WSB.
On the other hand, it is clear from the facts that the impetus of GME rally originally
generated from the Reddit/Wallstreet. The hype generated from this platform eventually
drove the sentiments of the retail investors (mostly young aggressive investors) to take
long position in the stock. Furthermore, the noise created from this extended it woes to
other retail investors, perhaps newbies, where the magnitude of participation was
further amplified. In light of these events, it is explicitly clear that the attraction of
investors’ interest in this stock was primarily driven by “emotions” that lead the stock
value of GME to be overpriced and thus parallels with the claim made by “Behavioral
Finance Theory”.
In light of the GME saga event, we learn that the claims of “alternative behavioral
theory” outplayed the concept of “rational finance theory”. Therefore, no matter how well
informed a short-seller is, taking position in a stock comes with risk especially in the age
of social media. In the case of GME, social media demonstrated itself as a powerful tool
that outsized market sentiments by creating a hype which targeted noise traders going
long on GME in a manner that eventually resulted in overpricing of the stock.

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