Markets

Should You Use Robinhood to Buy GameStop Stock?

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To say that the last few days in the stock market have been interesting would be a massive understatement, especially with stocks like GameStop (NYSE: GME) and AMC Entertainment (NYSE: AMC). As I'm writing this -- about 11:30 a.m. EST on Jan. 27 -- these stocks are up by 137% and 218%. Today. Trading is so frenzied that the popular trading platform Robinhood has reportedly experienced downtime today.

For investors sitting on the sidelines with cash in their brokerage accounts, it's only natural to wonder if there's more upside for these stocks. While I can't offer personalized financial advice, I can try to help make sense of what's going on so you can make a wise decision for yourself. Here's what you need to know.

Why are these stocks soaring?

The short answer is that we're seeing a massive short squeeze. Some big investors (hedge funds) sold many shares of GameStop short, which means that they borrowed shares to sell, hoping to buy them back at a lower price and make a profit. When more investors are trying to cover short positions than there are shares for sale, we get a short squeeze, and that's what we're seeing now.

While every short squeeze is different, here are the basics.

  • Investors bet against a stock by borrowing shares to sell (this is known as selling short), expecting the stock to go down. For example, there was reason to believe AMC wouldn't be able to survive the COVID-19 pandemic, and that shares would eventually go to zero.
  • Something occurs that causes investors to start buying the stock, thereby raising the price. This could be company-specific news -- in AMC's case, the CEO said bankruptcy is now off the table -- or it could be something as simple as large numbers of retail investors deciding to buy shares (which is the case with GameStop).
  • As the price rises, short sellers either decide to close out their positions to limit losses, or are forced to close them by their brokers (known as a margin call). Since closing a short position involves buying shares, this has the effect of driving the price up even higher.

In heavily shorted stocks like GameStop, this can go on for some time. In fact, GameStop's short interest was about 140% at the end of 2020, which means that for every 100 shares available to trade, 140 were sold short. That's a lot of short covering that could potentially happen.

How much higher could they go?

There are a few important principles investors should keep in mind when it comes to short squeezes.

  1. There is no upper limit to how long a short squeeze can last or how high it can go. So, if you're thinking of opening a short position to bet against the recent movement, I'd strongly suggest thinking twice.
  2. Stocks can move down just as fast when a short squeeze fizzles out. At some point, the short covering will subside. If there aren't enough buyers willing to pay the new, higher stock prices, it's not uncommon for a stock to come crashing back to Earth after a short squeeze.
  3. Short squeezes don't just make stocks go up; they cause a massive amount of volatility as well. In fact, since I wrote the first paragraph of this article, today's gains in GameStop and AMC Entertainment have changed to 146% and 227%, respectively.

So, to answer the question of "how much higher could they go?" I'd have to say much higher. But they could also reverse course and go lower just as easily.

Should I buy shares of GameStop or any of the other high-flying stocks?

The short answer is probably not. GameStop has already gone from a low of under $3 to a share price of $357 as I write this. And it has moved in a $131 trading range today alone.

The bottom line is that participating in a short squeeze in GameStop, AMC, or any of the other stocks that are rallying based on something other than company-specific news is not much different than buying a lottery ticket. There's nothing wrong with doing a bit of speculation (gambling) if you know that's what you're doing. But I'd strongly advise against putting any money you can't afford to lose into these stocks.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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