Why GameStop shares are on a wild, Reddit-driven run

But that frenzied optimism flipped, sending the stock briefly into negative territory late in the morning before it did another U-turn. It finished the day up 18%, around $77 a share.

The video game retailer's stock has soared more than 300% since the beginning of the year, charting an epic run for a brick-and-mortar business that, like other retailers, has seen its customers migrate online, forcing the company to shutter hundreds of stores last year. But unlike many other stocks that have flourished because of the disruptions of the coronavirus pandemic, GameStop's mind-boggling run has been fueled by a confluence of trading dynamics, pushing the stock price to dizzying heights, largely divorced from the fundamentals of the business.

Short sellers, or investors who had planned to profit from GameStop's fall, are now paying a hefty price, as the stock has not retreated as they had anticipated, compelling them to purchase GameStop shares at inflated prices to avoid even greater losses.

Here's what you need to know about GameStop's stock surge.

The start of GameStop's January rally can be traced back to August 2020, when Ryan Cohen, the co-founder of the online pet supply company Chewy, disclosed that he held a major stake in the company through his investment firm, RC Ventures. With a successful track record in e-commerce, Cohen has since pushed GameStop to move away from emphasizing its physical stores and reorient the business around digital sales, esports, streaming and mobile gaming.

Before Cohen's arrival, GameStop was seen by many on Wall Street as a relic of an earlier era, defined by a massive retail footprint and late-night lines for Black Friday and blockbuster game releases. With longer hardware life cycles, and the explosion of online and mobile games that transcend the older console model, the company struggled to adapt, drawing analogies to the fate of the record store. Last month, GameStop said net sales fell 30% in the third quarter compared with the same period in 2019.

In January, however, GameStop appointed Cohen and two other former Chewy executives to its board of directors, tasked with accelerating the company's transformation into a tech-centric e-commerce power house. Shares nearly doubled the week after the announcement.

Touting the optimistic case for GameStop's future, and the huge opportunity for gains in a company that many institutional investors had bet against, day traders on Reddit and other online communities snapped up the retailer's shares. Through its meteoric climb, people claiming to have purchased GameStop shares have framed their efforts as a collective, financial rebellion of sorts, delivering payback to wealthy short sellers that grew complacent and overextended themselves.

Part of GameStop's tremendous climb is tied to those who believe its shares will sink. At the start of the year, GameStop was among the most highly targeted companies by short sellers - investors who bet against a company and who stand to make money when a stock price falls. To short a company, a seller typically borrows a stock and then sells it, with the intention of buying the stock back at a later date, once the price drops. The seller then returns the shares to the entity from which it borrowed, and pockets the difference in price.

But in cases where the pessimistic bet fails to pan out, and the stock price rises, short sellers still have to cover their borrowed shares and are forced to buy the stock back at the higher price. This is known as a "short squeeze." In this situation, short sellers move to cut their losses and purchase shares that they expected to fall in value but in fact have risen. This money-losing "squeeze" can fuel a cycle of even higher prices, as short sellers buy more shares and drive costs upward.

"The 'short squeeze' story is that shorts think it's worth $20 or less, so at $25, they pressed, and when the stock went to $30, they covered, driving it to $35, where they shorted again. It's a vicious (or virtuous) cycle," said Michael Pachter, an analyst with Wedbush Securities. Pachter noted that roughly one-third of the company's 65 million outstanding shares are owned by company insiders and activist investors, and that when one of them sells, the "bubble may burst."

From its lows last April, when GameStop traded at $2.80, shares have risen more than 2,600%. Stock traders experienced wider volatility on Monday, as other companies targeted by short sellers rose and fell in dramatic bursts, including AMC and Nordstrom.

"The sudden, sharp surge in GameStop's share price and valuation likely has been fueled by a short squeeze, given the high short interest, and, to a lesser degree, speculation by retail investors on forecasts for the new gaming cycle and the involvement of activist RC Ventures," said Joseph Feldman, an analyst at Telsey Advisory Group, in a note on Monday.

"We believe the current share price and valuation levels are not sustainable, and we expect the shares to return to a more normal/fair valuation driven by the fundamentals."

Telsey also downgraded its rating on GameStop to underperform.

For now, GameStop enthusiasts haven't shown signs of wavering. Across consecutive sessions on Friday and Monday, trading was halted more than 10 times, as investors drove the price up by double digits.