If you haven’t already heard through Instagram, Dave Portnoy, Elon Musk, or CNBC, Gamestop (GME) was the new hot stock to buy the week of Jan. 23. In order to understand how and why this stock blew up overnight, one must first understand the market, stock shorting, and Reddit. 

First, we must step back and take a look at the big picture. What is the stock market? How does it work? 

In simple terms, the stock market is a place where investors can buy shares of ownership in public companies like Google, Amazon, Tesla, and of course, Gamestop. Investors can buy, sell and “short sell” these shares. Simply put, short selling is profiting off a stock after its value goes down.

Joe Mirza, Partner and Director of San Francisco based hedge fund HawksHead Capital, provides a comprehensive example of shorting. He says that shorting is essentially making money off a stock as it goes down, which is a tricky thing for one to wrap their head around.

“Imagine that I predicted that Rolex’s stock would go down. First I would find someone that owned a share of Rolex and borrow that share from them. Then I would sell it for… 100 dollars before I predicted the price would go down. Then, after it went down to 20 dollars I would buy it back and return it to the owner… I would make 80 dollars,” Mirza said.

Stock shorting sounds complicated, but it’s actually fairly simple. If the stock value happens to go up instead of down, you buy it back and return it to the original owner. Hedge funds – groups of professional investors that execute risky trades with other people’s money – do the most short selling. They think in terms of high risk, high reward. 

According to The National Law Review, GME has been inevitably heading towards bankruptcy since early 2020. As a result, Wall Street hedge funds predicted that the stock would go down, so they tried short selling it. These funds borrowed a GME stock and then let someone else borrow it, who let someone else borrow it, and so on. 

These hedge funds would work the stock, make their money, and lend it to someone else and collect the small interest fee that they were given after lending it. However, when the GME stock went up, there were more people borrowing it than there were actual available stocks. All these hedge funds scavenged to buy the stock to return it to the owner, but there was more demand than there was supply.

At this time, a Reddit channel named “Wallstreetbets” began telling their followers about the situation at hand and encouraged them to buy GME and raise the stock price because of how valuable it had become. Hedge funds foraged and negotiated with Reddit users for those stocks. Mirza said that they were “desperate to find a share in order to fulfill their obligation” – this is called a “short squeeze.” 

Melvin Capital is one of the better-known hedge funds that wedged themselves into the GME chaos. At the beginning of January, they predicted that the price of the GME stock would collapse from 20 to 40 dollars in a matter of weeks or months. Soon after, they shorted an unknown number of shares and lost billions of dollars – 53 percent of their portfolio to be exact. 

“What will probably happen in a week or two is enough people will have covered their stock by buying it at this new, crazy price. The stock price will start to fall very quickly – it could happen in days or even hours,” Mirza said.

This means that despite the GME success stories about overnight millionaires, it’s important to remember that buying and selling stocks is a risky business – millions of dollars can be lost in hours.