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The recent rallies and volatility in the stocks of video game retailer GameStop and movie theater chain AMC can be linked to a term known as “frenzied trading,” according to Itay Goldstein, Wharton professor of finance and economics who co-authored a research paper in 2013 on that subject with Emre Ozdenoren, a professor of economics at London Business School, and Kathy Yuan, finance professor at the London School of Economics.
In that paper, titled “Trading Frenzies and their Impact on Real Investment,” the authors provide a theory of what could generate a trading frenzy. “A group of small traders coordinate to trade in the same direction knowing that if they all do it, this will benefit the monetary value of their positions,” said Goldstein. “The channel goes through a financially constrained firm: If everyone sells, the firm will have a hard time raising money, which will decrease its value, benefiting everyone who sold; the channel can also work for buying.”
According to Goldstein, what happened with GameStop was similar in the coordination motive, but the channel went through the short squeeze, at least to some extent. “If everyone buys, short sellers will be squeezed and forced to buy, which increases the stock price, benefiting everyone who buys.” As it happens, after reaching a high of $483 on January 28, the GameStop share price has fallen equally precipitously to $64 at close of trading last week.
“A trading frenzy occurs when the incentives are such that different market participants want to trade in the same direction,” Goldstein said in an interview last week on the Wharton Business Daily radio show on SiriusXM. (Listen to the full podcast here.) “Typically, market forces go against that. So, when everyone buys, it’s a good time to sell. This brings balance in the system, which helps stabilize markets.”
A typical episode of trading frenzy is where “bear raids” occur, where short sellers gang up against a stock and sell it, bringing down its price. As a result, a financially constrained firm that is at the receiving end has “a hard time raising capital and financing itself,” said Goldstein. “As a result, the value of the firm will drop, and short sellers will benefit from their position.”
“If you have a firm that is subject to a short-selling attack, and the price drops dramatically, the firm will have a hard time raising capital and investing.” –Itay Goldstein
The trading frenzy in the GameStop stock also saw “everyone wanting to trade in the same direction at the same time,” except that they wanted to buy it, Goldstein continued. Here, the investors who bought the GameStop stock pitted themselves against large hedge funds that had outstanding short positions on the stock.
Buyers of the stock reasoned that if all of them buy the stock, the short sellers would find it expensive to maintain their positions and face the so-called “short squeeze,” he explained. An unrelenting short squeeze would compel short sellers to eventually buy the stock to fulfill their delivery commitments, which would cause the stock price to rise and thereby bring profits to investors who were bullish on it all along, he added.
Coordination on Social Media
The idea of coordination led Goldstein and his co-authors to make some predictions that are related to what has happened with GameStop. For example, they wrote: “A large volume of activity in such [internet] forums could suggest that speculators have more common information than private information and so trading frenzies become more likely to occur.”
Goldstein noted that behind the trading frenzy is the idea that people coordinate to trade in the same direction. “The emergence of Reddit and other forums where they were exchanging information and tactics and so on, certainly helped them develop this coordination mechanism that led this frenzy to emerge,” he said.
“The complication for regulators is that actual information that is supposed to be incorporated in prices can also be diffused through social media,” Wharton finance professor Jules H. van Binsbergen told Knowledge@Wharton for a recent story on the GameStop and AMC price rallies. “This can still lead to sizeable price changes, but those price changes make financial markets more informative, which is beneficial to the real economy.”
The GameStop episode is “a curious case,” Goldstein said, “where you have all these retail traders coordinating on the internet to take long positions against a short seller and make it more difficult for the short seller to maintain the position.”
“Coordination among speculators is sometimes desirable for price informativeness and investment efficiency, but speculators’ incentives push in the opposite direction, so that they coordinate exactly when it is undesirable,” Goldstein and his co-authors stated in their paper.
“At the end of the day, we care mostly about the real economy, not so much about just the financial market itself.” –Itay Goldstein
Trading frenzies are seen also in other contexts, such as with currencies, Goldstein said. “You have governments trying to maintain the exchange rate of the currency at a particular level, and then you have speculators sensing [that] this may be out of equilibrium, and they are all coordinating, trading against the currency,” he said. “Eventually you see governments abandoning the exchange rate in those situations.”
The Real Economy Effect
The repercussions of frenzied trading on the real economy could run wide and deep, which Goldstein and his co-authors explored in their paper. “Typically, when we think about trading in the financial markets, we should take a step back and ask, do we really care?” he said. “At the end of the day, is this just a sideshow, a little casino where some people are making money and some people are losing money, but it doesn’t have any real effect? Or does it have a real effect?”
Those questions had intrigued Goldstein for long and spiked his interest in the so-called real effect of financial markets. “When something happens in the stock market, does it really affect firms, investment, employment, production? This is the real economy,” he said. “At the end of the day, we care mostly about the real economy, not so much about just the financial market itself.”
That research interest led Goldstein to look for and track the “feedback effects” from the financial market to the real side of the economy such as investment, employment and production. In the short-selling attacks marked by trading frenzies, “the real effect was very clear and very immediate,” he said. “If you have a firm that is subject to a short-selling attack, and the price drops dramatically, the firm will have a hard time raising capital and investing. This will have a real effect on investment, on the production of the firm, and so forth.”
Goldstein’s paper affirmed that real effect: “Both anecdotal and large-sample empirical evidence suggests that the feedback loop between firms’ operations and the trading of their stocks is an important element in the emergence of trading frenzies.”
In the case of GameStop, the real effect may be limited in terms of its ability to raise fresh capital. But there would be repercussions of the price volatility and the surge in trading volumes — on January 25, trading volumes in the stock were up nearly 10-fold to about 180 million. “Some people are making money, and some people are losing money,” Goldstein said. “And the fact that so many people are losing money could eventually have some disturbances for the real economy.”
“The fact that they could coordinate [the trading frenzy] over social media and take such massive actions, I think gives people a pause.” –Itay Goldstein
Underlying the trading frenzies in the GameStop and AMC stocks were “very strong fundamental motives” on both sides of the equation. The short sellers had “very strong fundamental concerns” about the fortunes of the two companies, and the pandemic had made those problems bigger. “Looking into the world after the pandemic, things might change in a way that will not help the long-term prospects, so they had a reason to have these short-sell positions,” said Goldstein. The hedge funds had the biggest short positions in those stocks.
On the other hand, retail investors that took long positions on those stocks and started buying them “had a more fundamental optimistic view,” Goldstein continued. “They said, at the end of the day GameStop has a strong brand, and they need to make some adjustments.” Also floating around were ideas that the firm may go the e-commerce way and replicate some of its physical business in the online environment, he added. “So, there was a situation of a basic disagreement, which is healthy for the financial markets. But it all went out of whack with this trading frenzy and coordination that led the stock price to explode and then crash down.”
As the dust settles down, discussions will begin about reforms to financial markets to try to prevent price volatility as in the case of GameStop, said Goldstein. “When you have this kind of a speculative attack, you would like to put some sand in the wheels of financial markets and slow them down.” Already, members of Congress have called for a “transaction tax” to curb excessive short-selling. Financial regulators concluded that in the GameStop trading frenzy, “the core infrastructure was resilient,” and that it stood up “during high volatility and heavy trading volume.” But they are continuing to study the impact on investor protection and efficient functioning of the markets.
Even so, some regulators want greater transparency for investors, while others want trading suspensions. Goldstein said he expected more examination of the short-selling process and the role of social media. “The fact that they could coordinate [the trading frenzy] over social media and take such massive actions, I think gives people a pause.”