Reddit takes on Wall Street, Explained
Reddit takes on Wall Street, Explained
The GameStop saga simply explained in less than 10 minutes
You’ve likely heard a bit about the market mania surrounding Robinhood, Gamestop, Melvin Capital, and a handful of other hedge funds and stocks, so what the stonks happened? The short story is a Reddit subgroup known as Wall Street Bets agreed to buy up a handful of targeted stocks driving prices to astronomical highs (to the moon 🚀 ).
Less than two weeks ago, GameStop (GME) was trading around $19-20 per share. On Wednesday, it traded at $483 before dropping to $112 less than two hours later. Then, on Friday, it closed at $325. Behind the insane volatility was the commander of the nameless Reddit army called, Roaring Kitty (can’t wait for when McGraw Hill has to write that one into next year’s books). Before we break down what happened, let’s be clear – this is not normal Wall Street behavior.
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The Big Stonk
What is Wall Street Bets (WSB)?
It is a message board or “subreddit” on a public forum site called Reddit. With over 7.4m followers, WSB has been a place for day traders to publicly discuss their trades, share investment memes, and generally troll each other. It never really caused any harm until Roaring Kitty stumbled onto an opportunity that united the community in a single targeted movement: buying up heavily shorted stocks.
What does it mean to “short” a stock?
Shorting a stock is an investment strategy that speculates on the potential decline of a stock’s price. Simply put, if you think a stock is overvalued you “short” it, betting that the price will go down. This is the counterpoint of a “long” position.
Okay, but how does it work? Simply put, an investor borrows shares of a stock from their broker and immediately sells them at the current market price. At a future date, the investor will buy back the shares and return them to their broker.
For example: Harambe borrows 1 share of stock XYZ at a price of $10 from his broker. Harambe’s broker then immediately sells that share in the market for $10. As of now, Harambe is “short” (owes his broker) 1 share of XYZ and has $10 in his pocket. At some point in the future, the price of XYZ goes down to $6 and Harambe buys a share of XYZ with his $10 and returns it to his broker. Harambe just made $4 on the share loaned to him, and he closed his position with the broker.
Shorting is risky, and has an unlimited potential for loss
A stock has a finite amount of possible downward movement. If an investor opens a short position at $10, it can only go as low as $0 (-100%). However, there are no limits to how high a stock can theoretically go. What happens to a short investor who was wrong about the stock going down?
If the price of XYZ goes up to $20, and Harambe only has the $10 he borrowed from his broker, Harambe has to come up with another $10 to buy a share that he can return to his broker. Harambe’s broker wants to ensure Harambe can afford to pay him back. To do so, Harambe’s broker requires him to open a “Margin Account” to initiate a short position.
When Harambe opens a short position in his margin account, he pays an interest on the borrowed shares until the position is closed. Additionally, Harambe’s broker requires him to hold a balance in his account as “collateral” to ensure Harambe will be able to pay back the broker if he is wrong about the stock going down. The Federal Reserve sets the minimum value (“maintenance margin”) that Harambe must have in his Margin Account. If Harambe’s account falls below this minimum, he must add more funds or the broker may sell the position for him.
Often, when a short seller like Harambe sees the stock price rising, he will cut his losses by closing out his position. To close out, Harambe will have to buy a share of XYZ at $20 ($10 higher than the price he borrowed it at) and return the shares back to his broker. If Harambe doesn’t close his position, his broker will demand that he either fund his Margin Account with more money or suggest closing out the position every time the stock rises. This is known as a “margin call.” The broker may close your short position automatically if you fall below the maintenance margin.
Let’s recap:
To open a short position an investor opens a margin account.
Short selling involves borrowing stock from your brokerage and selling it on the market in hopes of buying it back at a lower price at a future date and returning it to the broker (note: closing a short position requires an investor to buy back into the market).
To make sure you’re good for it, the broker requires you to maintain a margin maintenance amount in your account and can close out your account if you follow below the required amount.
What is a Short Squeeze?
The term heard all over the Street last week. A Short Squeeze occurs when the price of a shorted stock begins to rise and short sellers are forced to close out their positions, typically for a loss. As short sellers close out their positions, they inadvertently apply buying pressure on the stock further driving the price up and forcing other short sellers to close out their positions and push the stock higher, which repeats over and over. It’s a domino effect on short sellers triggered by an increase in a stock’s price when short sellers bet wrong and brokers apply margin calls.
Short squeezes are characterized by rapid increases in price and can only happen under unique conditions, with the main factor being a substantial amount of the total available shares (+15%) being shorted.
What happened to GameStop?
The “research team” at WSB screened for stocks that combined the following criteria:
A substantial amount of the float was being shorted at that moment in time
Limited amount of shares that trade daily in the market (low volume)
Next, WSB followers agreed to purchase shares of these companies (e.g., GME), push the price up (to the moon 🚀 ,they said), and hold them. As a result, short sellers looked to close out their positions. The problem they encountered was that there was a limited amount of shares they could buy, and the WSB followers bought and were holding a significant amount of them. (This is the “hold the line” recurring comment on social media.)
Investors with short positions had to buy shares at increasingly higher prices to close their short positions. This preambles a self-reinforcing cycle, as many investors with short positions scramble to buy the limited shares available to close their short positions and generate further buying pressure. The higher the price, the more margin calls, so more short positions are covered making the price rise, which in turn makes more shorts cover, pushing the stock up again, and so on. In this particular case, it was exacerbated by options in what is known as a Gamma Squeeze (think, a short squeeze but sprinkle some steroids on it).
Typically, a strategy like this can only be implemented with massive amounts of capital (e.g., hedge funds... good luck proving it in court) or in this case, a massive coordinated effort by retail investors.
Is this class warfare?
Occupy Wall Street 2021: Twice as dumb but twice as effective?
The short answer is NO. The media has made this out to be a “rebellion” or a “David vs. Goliath” story. Hell, even the people at WSB seem to support this theory, and many more believe they are “taking on Wall Street.”
Why? Because it sells. Let’s be honest, who doesn’t want to stick it to the suits and root for the little guy? Who doesn’t like watching the world burn a little? Sorry to burst your bubble, but that’s just TV... as if Wall Street isn’t benefiting from this. Let’s clear that narrative up first and take a look at who profited from the squeeze.
Sure, a couple of hedge funds got squeezed and lost a lot of money. Melvin Capital lost 53% in January! However, it’s only a select few hedge funds that are involved in aggressive short strategies in companies that fit the criteria of WSB targets. Many, MANY more held long positions such as Fidelity, BlackRock, Vanguard, and Michael Burry (of course, Michael f****ing Burry was involved - a WTM hero).
The true aftermath, at least in the short run, is that a few people on Reddit did make a lot of money and some hedge funds did incur heavy losses on certain positions. However, the real winners are the corporate executives who hold shares of those companies, numerous institutional investors, and Wall Street in general due to the sheer trading volume (as they implicitly make commissions on every trade!)
Biggest Losers?
Robinhood, Interactive Brokers, and Melvin Capital who lost roughly $3 Billion. On Thursday, Robinhood, the alleged broker of the people, placed restrictions on multiple stocks targeted by WSB, while many other brokers followed suit. Users of Twitter and other social media platforms gave them a piece of their mind and roughly 100K 1-star reviews followed by a class-action lawsuit shortly after.
What drove Robinhood to act like this is still hard to explain. Most likely, clearing houses restricted their ability to trade by raising capital requirements, and the substantial volume and volatility made them decide what would be less risky to them. Clearing Houses act as intermediaries between buyers and sellers and are responsible for settling trading accounts and effectively clearing trades.
Interactive Brokers CEO saying they limited trading to “protect the market” surely helped the media’s narrative on how the game is rigged. Furthermore, Robinhood limited users ability to buy shares of specific stocks, while not limiting users from exiting these positions. While this can be naturally explained by the underworkings of securities clearing, in this particular instance the people trying to buy were retail investors (the people), and those trying to sell and close positions were the big dog hedge funds. Turning this move into a tool for the media to say it’s David vs. Goliath and Robinhood just chose Goliath.
Was this legal?
Well, it looks a lot like stock manipulation. A reason why many bankers and traders have been arrested in the past. People urging others to “keep buying and holding” does resemble a coordinated effort to manipulate a stock.
However, it will be extremely difficult to prove this in court, not even mentioning how hard it will be to arbitrarily define who is to blame for the literal millions of WSB redditors and Twitter users.
What’s next?
Hard to tell, but Wall Street may take measures to prevent an event like this from happening again by adjusting risk parameters surrounding margin accounts, options and short position trading all while angrily shaking their fists, how dare the retail investor defy the suits?!
After investment managers close out their short positions they will likely complain about the 13F Filings. The SEC filing discloses, in the name of transparency, the positions long, and short, that funds with over $100 million under management hold at the end of every quarter. Option prices will probably increase so as to limit the risk exacerbation that gamma squeezes can cause, while brokers will most likely increase margin requirements.
Congress and regulators like the SEC, FINRA and the CFTC will most likely launch investigations to understand who may have been behind this, while defining how to limit option trading and what rules may need to be modified to disincentivize this type of behavior.
Some regulatory innovation is expected, particularly surrounding social media and the definitions of stock manipulation and accountability. However, what happened with Robinhood truly put into perspective how risky clearing and settlement procedures work in Wall Street. Updated regulation and/or oversight on clearing houses should follow as well.
Bottom line:
While this wasn't some major toppling of Wall Street or a revolution per se, it has “demonstrated that even god-kings can bleed.” Despite not taking down the hedge fund empire, retail investors proved that they could shoot down a death star.
Investment managers will most likely think twice next time they consider opening a short position, and that is not minor. This event has effectively exposed a number of systemic flaws in the capital markets, and the consequences of risky investment behavior. Despite this not being the revolution many would hope for, it is a significant wake up call; a cold dunk in the proverbial pool.
Financial analysts, economists, researchers, politicians and news anchors will try to explain and rationalize market behavior. The truth is that markets are made of people and sentiment is what drives short spurs and bursts.
In the words of Isaac Newton, “I can calculate the motion of heavenly bodies, but not the madness of people.”
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This writing is for informational purposes only and the author/s undertake/s no obligation to update this article even if the opinions expressed change. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services in any jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. The author/s expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.