GameStop drama a win for the little guys? Yes and no.

Two weeks ago, famed short seller Andrew Left planned to appear live over the internet to explain why shares of GameStop, a retail chain selling video games and consoles, would drop dramatically. 

The event never happened. Instead, hackers attacked his social media accounts, published personal information about him, used threatening and profane language, and reportedly even texted his children. A day later, GameStop stock jumped 50% and closed at $65.01 while Mr. Left signaled he would no longer be commenting on the company. That was Friday, Jan. 22, the first of five days that would shake the investment world.

The saga of GameStop is proving to be irresistible to investors and non-investors alike because on the surface at least it illustrates a rare phenomenon: individuals beating Wall Street pros. For months a band of small investors on an online Reddit forum called WallStreetBets had been buying up shares of GameStop while hedge funds kept selling them, sure that the price would nosedive. Instead, the share price climbed in six months from $4 to $347 a share. Last week, a high-profile hedge ended its short selling, declaring huge losses.

“Wall Street is rigged against the small guy and it’s been that way for 100 years,” says Andrew Stoltmann, an investment fraud lawyer based in Chicago. But “against a couple of hedge funds, David has finally beat Goliath and it’s absolutely hysterical. There’s a reason why so many people are cheering these guys on.”

The GameStop story is also focusing a bright light on the ethics of short selling hedge funds. They are so lightly regulated that their opaque methods of gambling on a company’s demise are perfectly legal while, in a Dickensian twist, the transparent efforts of hundreds of individuals to prop up a company probably are not. 

And GameStop also illustrates, so quickly on the heels of the Capitol insurrection, the power of social media. It can not only quickly spread a compelling idea but easily organize hundreds or more around a plan of action that can stir political violence and push stock prices far beyond a reasonable level.

These are large issues that regulators and Congress are likely to delve into in the weeks ahead. But for Zack Ewing and many other of the 20- to 30-year-olds who piled into GameStop, it was also personal.

Day 2: Jan. 25 – GameStop closes at $76.79

Mr. Ewing, a product designer in Johnson City, Tennessee, had seen the GameStop chatter pop up on Reddit forums for months. The thrust of the posts on WallStreetBets was that Wall Street was undervaluing GameStop, seeing it as a tired old retailer in physical stores without a strong online strategy. By buying the stock, one could make money. But more recently, the tone of the Reddit posts had changed.

Mr. Ewing noticed that forum users began touting GameStop as a way to beat Wall Street, specifically hedge funds that had bet against the company. 

GameStop holds a special place in the hearts of 20-somethings, he says, because that’s where many of them bought their video games as children. The idea of taking on Wall Street added special allure because the ravages of the financial crisis were still fresh in their minds.

“My parents had multiple properties, and in 2008 they had to downsize,” he recalls. It was tough for them. It was tough for my wife’s parents. People I knew who were near retirement age almost overnight saw a third of their retirement wiped out. Big banks and investment houses made reckless bets on sketchy mortgages. But no one was held accountable, he adds. “Not only was there not a slap on the wrist, you’re going to take my taxpayer money to bail these people out?”

Mr. Ewing, a conservative investor, wasn’t quite ready to jump in, but he was “excited that these funds were going to get a little taste of their own medicine.” 

Hedge funds operate in the shadows of the investing world. They’re not allowed to advertise and can only work with wealthy people who typically have several million dollars to invest. In exchange for that low profile, they are only very lightly regulated. To justify their fees, they typically use complex strategies and sometimes exotic instruments to try to earn more than what they could from holding common stocks. They closely guard their investment strategies, usually not even informing their investors.

One of those strategies is short selling companies. Short selling involves borrowing stocks from a broker at a high price and purchasing the option to buy it at a lower price. In the simplest form, it would be borrowing a stock at $100, watching it plunge, and buying it at $50 to give back to the broker, pocketing $50 per share minus expenses. 

The trading on Jan. 25 was particularly volatile. Out of the gate, the stock jumped to nearly $120, almost double its Friday close, then shed most of that gain only to climb slowly back. If Reddit investors were suddenly going to try to stick it to hedge funds, then they would have to keep the faith and hold onto their stock no matter how dizzying the price swings. Entrepreneur Elon Musk, whose Tesla electric-car company was the target of short sellers for years, tweeted his encouragement, playing off GameStop’s name with an internet term for stock: “Gamestonk.”

Day 3: Jan. 26 – GameStop $147.98   

After months of labor, Reddit investors had their day of triumph. Melvin Capital, one of the hedge funds known to be shorting GameStop and other stocks, including movie theater chain AMC, threw in the towel, losing a whopping 53% on its investments in January alone. Two other hedge funds advanced the firm nearly $3 billion to keep it afloat.

At the same time, the David-and-Goliath narrative begins to crumble. While Reddit individuals were buying GameStop, so were other big Wall Street firms. Senvest Management, another hedge fund, cashed in its holdings of GameStop and earned nearly $700 million. Blackrock, a huge asset management firm, revealed in a regulatory filing that it owned 13% of GameStop at the end of 2020, setting it up potentially for a $2.4 billion profit. 

“The David and Goliath story is a false narrative,” says Sinan Aral, director of the Massachusetts Institute of Technology Initiative on the Digital Economy and author of “The Hype Machine: How Social Media Disrupts Our Elections, Our Economy, and Our Health – and How We Must Adapt.” The Reddit investors had plenty of help from big players, who moved the needle on the stock. How much help and whether there was any direction remains unknown.

Day 4: Jan. 27 – GameStop $347.51

Now that Reddit investors knew they had the short sellers on the ropes, they hoped to stick together for one last push to finalize the short squeeze.

Mr. Ewing jumped in, buying some shares for $1,000 “with the full expectation that they could absolutely go to zero,” he recalls. He loved the idea of some comeuppance for hedge funds. 

Prices soared again, more than doubling and trading above $360. Then officialdom begins to act. The Nasdaq stock exchange briefly halts trading in GameStop, AMC, and one other stock – a normal occurrence when a stock’s price begins to swing wildly. TD Ameritrade limited some trades on both stocks, including others. After the trading day, the Securities and Exchange Commission, which regulates stock trading, said it was monitoring the situation. 

Day 5: Jan. 28 – GameStop $193.60

Before the market opened, Robinhood – an online trading platform favored by many of the Reddit investors – announced it would no longer allow its customers to buy GameStop. They could only sell. The reaction was furious and immediate. While the company said it couldn’t continue to allow buying because of the huge amount of margin money the exchange was demanding for trading in such volatile stocks, the move seemed for many a blatant attempt by Wall Street powers to protect their own. 

With few retail buyers – while the hedge funds were still allowed to sell – the share price plunged 44%. And Congress noticed.

“This is unacceptable,” Democratic Rep. Alexandria Ocasio-Cortez of New York tweeted about Robinhood’s decision. Republican Sen. Ted Cruz of Texas chimed in with his support. The fact that politicians at opposite ends of the spectrum could agree on the right of individuals to invest suggests that Congress will begin to look into the GameStop saga to see who was behind the run-up in share prices, whether short sellers were aboveboard in their push to get the price down, and whether hedge funds in general need more scrutiny.  

Congress has rarely even considered regulating hedge funds, says Charles Geisst, a historian and author of “Wall Street: A History.” But with the spotlight now on them, this might be a propitious time to begin to tackle the issue. “No one will ever feel sorry for short sellers,” he adds.

By casting a critical eye on companies, hedge funds play an important and useful role, some economists argue. They counter the hype that Wall Street sometimes generates around particular stocks. That skepticism helps the market offer more realistic pricing and adds liquidity to the market. 

Still, it’s clearly not popular now. Six days after canceling his live event, Mr. Left announced he was walking away from 20 years of uncovering fraud in companies and short selling and would concentrate instead on good buying opportunities for investors. “When we started, Citron was supposed to be against the establishment,” he said in a YouTube video. “We’ve actually become the establishment.”

The irony is that short selling is legal, while, under current law, the Reddit investors who tried to pump up GameStop stock through coordinated trades probably broke laws against stock manipulation, says Mr. Stoltmann, an investment fraud lawyer based in Chicago. But there’s no way that they’ll be prosecuted, he adds. “The SEC would have a mutiny of near biblical proportions if they did this – a mutiny by the public, a mutiny by Congress, a mutiny by the press.”

“The $64,000 question is whether this is a one-time aberration or whether it’s a trend,” he adds. “If these little guys band together and they consistently engage in this behavior, then that’s a market destructor.”

In a note this week, RBC Capital Markets said they expected more such activity as retail investors plow money into other beaten-down stocks.   

“We need a thorough investigation,” says Mr. Aral of MIT, given the recent high-profile instances of social media being used to organize illegal actions. “Do I think Congress has the stomach to regulate social media? I certainly think they have more than ever before.”

Mr. Ewing sees small investors as more powerful agents of change. “There’s this historical reference to Wall Street as ‘smart money.’ But it’s not smart money and dumb money anymore. It’s fast money vs. slow money,” he says. “I think that individual money is fast money and fast money is much quicker to embrace climate consciousness, personal LGBTQ+ [rights], racial equality. Those problems are much easier to solve with your dollar than [by] voting for a representative. ... You as an individual have a lot more agency with your dollars than your vote.”

On Thursday, Feb. 4, GameStop closed at $60.06 a share, down 83% from its peak close eight days ago.