There is 1 company, that company has 1 stock. Alice is the shorter and expects the stock to drop.
* How shorting works normally:
Alice thinks the price will lower this week. On Monday, Alice borrows a stock from Bob. She sells that stock immediately on Monday. On Friday at the end of that week, she buys a stock again and hands it back to Bob, plus a small fee for his troubles. If the stock price went down during the week, you can see that Alice made a profit.
* What happened for Gamestop:
Melvin thinks the price will lower this year. Melvin borrows a stock from Rudy. Melvin sells that stock, and unbeknown to him he sells it back to Rudy. Melvin borrows another stock from Rudy which unbeknown to him he sells again to Rudy. While there exists only 1 stock, Rudy now has 3 stocks of which he borrowed 2 to Melvin. Melvin owes Rudy 200% of all available stock, which he needs to hand back at the end of the year.
* What is the short squeeze Rudy/Reddit is currently doing on Melvin Capital?
Well, in reality, Melvin Capital has 1.5 stocks borrowed for every stock in existence (I'm not sure how much of the total stock was actually liquid, so I'm not sure how many rounds Melvin needs to go through to cover all their shorts).
Today it is the end of the year. Melvin needs to hand Rudy back the stock. However, the only person he could buy it from, is Rudy himself. Now Rudy is free to set an arbitrary price for his stock AND meanwhile buy up all other available stock at ridiculous prices. The only stock Melvin can buy, is from Rudy, or from other people at at least Rudy's price point. And Melvin needs to buy that stock to then hand it back to Rudy, after which Rudy can sell it yet again at an even higher price point for Melvin to hand it back again. Rudy makes a lot of profit, by squeezing out Melvin after making the market illiquid and overpriced. Effectively, the game is such that the entire capital of Melvin is now for Rudy. Melvin must buy something from Rudy, no matter how high Rudy sets his price.
An alternative is for Melvin to borrow another stock from Rudy, handing it back to cover for the last borrow. However, this way Melvin is only digging himself into an even deeper hole stacking up fees (the fee Melvin pays for Rudy's troubles is currently at a 130% interest rate).
* What is on the line?
Melvin Capital is 3 billion. The question is how much Reddit is Rudy, how much stock Reddit managed to control. If Reddit manages the squeeze, the squeezers will basically share among each other 3 billion. If Reddit does not manage, a lot of people will hold a lot of Gamestop stock at probably way lower prices than they bought.
Melvin Capital appears to have received a capital injection of 3 billion from Citadel today, doubling the stakes in an all or nothing with Reddit. So wallstreetbets is now standing to either gain 6 billion or losing a lot of money. Which sounds big to us, but is probably just another Wednesday for wallstreetbets...