Don't understand the GameStop stock drama? Read this

Still don't understand the GameStop stock drama? Read this

Still confused by the GameStop stock market saga? Us too.

Fortunately, Dr Paul Mazzola of the Faculty of Business and Law at UOW had the nous to both understand it and explain it to unsophisticated investors like us.

The story began when an investor in a failing electronic games retailer, GameStop, used their social media network to encourage gamers to purchase GameStop stock in an attempt to support the business.

To the investor's surprise, many lay-people (known as "unsophisticated investors") took up the cause and began to buy large amounts of stock.

So far, so straightforward.

In the background, however, there had been more happening. Hedge fund managers had noticed GameStop's initial poor performance, and decided to short the shares.

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"This means they sell the stock at the price it is today without owning it," Dr Mazzola said.

"Their expectation is that the share price will continue to fall, and they subsequently buy the shares at a lower price than they sold them for, before delivering them to the purchaser."

This can be done by borrowing the shares, or using options, but the easiest way to think about it is to imagine a store. The owner sells you a product they don't have in stock on Monday, on the understanding that they will order it in and deliver it to you by Wednesday.

The value of the good you ordered is falling, so the owner purchases the product on Wednesday for a lower price than they would have paid had they bought it on Monday, when you placed your order.

You have already committed to paying the price agreed upon on Monday, and the store owner makes a profit from the difference.

As a result of all the unsophistcated investors purchasing stock, the price went up, not down. As a result, the hedge fund manager had to purchase the stocks at a considerably higher price than they had sold them for, in order to make good on their sales.

This resulted in hedge funds making significant losses - for some companies, in the billions of dollars.

But the story doesn't end there.

Dr Mazzola said several issues have emerged from the GameStop debacle.

One is that those who overinvested on GameStop stock may lose a lot of money when the price of the shares drops - and that is a when, not an if, he said.

"The price of the shares are so high they no longer reflect the value of the company," Dr Mazzola said, "over the long term market forces will generally bring them back into line."

"Research shows when there is a run on shares the sell off often happens quicker than the run up, so these investors could be stuck with the shares, unable to sell them.

"Some of them may be quite wealthy, but others may not be able to afford the loss."

On the flip side, hedge fund managers have been punished for manipulating the market.

"It's good that these hedge fund managers have had their bluff called - there's been some market discipline," Dr Mazzola said.

"The share market has a habit of punishing the exuberant and the greedy."

As for how this turn of events will affect the market into the future, no one knows.

"This is the first time social media has been used to corral investors in such a way," Dr Mazzola said.

"It's a new, surprising phenomena and it's caught us all off guard. The power of social media has been revealed again.

"Anyone who plays the markets takes a risk, and theres no problem with that - but people should only take on investments that are in tune with their risk appetite and risk profile."

Dr Mazzola said the best way to manage your investment risks is to get educated on how the market works - and accept that even if you're the brightest hedge fund manager, one day you may suffer a surprising loss.

This story Still don't understand the GameStop stock drama? Read this first appeared on South Coast Register.