The RSMR Weekly Broadcast - weaponised options trading & the short squeeze on hedge funds

There's no shortage of knowledge and expertise at RSMR! Each week we get our heads together and talk about events in the world and how investments are affected by them. Our broadcast tackles a wide range of issues facing investors from green gilts to the global shipping crisis and bot extortion to the legislation of tech giants. We like to think of it as cracking content for the financial adviser. Have a read & get clued up...

As a trader on the stock market you would generally choose a stock that you think is likely to go up in value in the future, you’d buy it and when it does go up, you’d sell it and make a profit. But what is shorting a stock? Shorting, or short-selling is when an investor borrows shares and sells them, hoping he or she can scoop them up later at a lower price, return them to the lender and pocket the difference. So instead of buying and then selling, you sell and then buy. It’s public knowledge that various companies have shorts on stocks and when hedge funds are short-selling, they must declare it to the public.

GameStop, a bricks and mortar retailer in the US selling video games, was a prime target for short-sellers. The pandemic has hit GameStop hard, their stores are closing, and the stock was really struggling. Hedge funds shorted the stocks expecting them to fall and make them a large profit. As is usual practice, some short-sellers put out press releases declaring their intention, convincing people there’s an issue with the stock and forcing through their opinion, encouraging traders to sell the stock, creating a self-fulfilling prophecy and lining their pockets. But this time, users on the Reddit message board r/wallstreetbets had other ideas and GameStop became the focus of a trading war between amateurs and Wall Street pros.

Short-selling is legal and relatively common, but there is great debate as to whether it’s ethical. Hedge funds are basically making money from companies that are failing and, in effect, can be seen as contributing to their demise. The aftermath of their gain can lead to job losses and creditors not getting paid. 

Reddit is a social network of online forums, or ‘subreddits’, where individuals can create posts about shared interests and interact with other members of the forum. One of these subreddits, wallstreetbets, started the year with around 1.75 million users but now has over 8 million.

A member of the forum posted a message that they believed the hedge funds’ collective short interest exceeded 100% of the available shares and to encourage the community to buy GameStop shares and call options to see whether, through the power of people, they could fight back against short-sellers and make them suffer a loss. As a direct result, GameStop’s stocks gained almost 1,800% in January and short-sellers, having no choice but to close their short positions, suffered billions of dollars-worth of losses. Conversely, the wallstreetbets forum was full of screenshots of investment accounts with multimillion-dollar gains and users egging each other on to continue buying up the stock.

Melvin Capital became a target after the firm disclosed its bet against GameStop in regulatory filings. The result - Melvin Capital reportedly exited its bet against GameStop, losing in total around $3.75 billion. And they’re not alone, another high profile short-seller, Carson Block from Muddy Waters hedge fund also sustained heavy losses.

Amateur traders effectively pushed the share prices up and the hedge funds being forced to close their short position created more buying pressure on the stock, pushing it to extreme levels. It’s a clear example of how a new army of day traders have effectively ‘weaponised’ financial derivatives to their advantage and, not surprisingly, the Reddit community has attracted serious attention and is gaining hundreds of thousands of new members each day! And has the fight back made a difference? In the wake of the attack, Mr Block commented ‘it’s not rocket science, massively reduce your shorts or risk going out of business’.

The implications are that retail investors have a lot more power than markets previously thought, but there is a question mark over whether this action is also a form of market manipulation. This type of mass campaign creates huge gains and losses and it’s as easy as a post on a forum. Members of the Reddit movement will have made millions of dollars in the process of making the hedge funds pay and some of the platforms are trying to limit this type of trading. Robinhood stopped traders buying shares to protect their interests, serious damage can be done when traders don’t understand their position, but lawsuits are now being proposed against Robinhood on the Reddit forum. It’s a mess!

If we’re saying it’s wrong for the Reddit community to encourage mass buying of stocks, surely, it’s not right for the hedge funds to profit from shorting either? Some say the short squeeze on hedge funds is a victory over the broken system. The power of the retail investor is clear, but will this warning-shot stop shorting in its tracks? Once bitten twice shy says maybe in the short-term, but does the system need to change to protect our assets and encourage growth rather than preying on the weak?  

QUIZ QUESTION: How many subreddits are there?

LAST WEEK'S ANSWER: The name of Google is derived from the number googol, which is equal to the number 1 followed by 100 zeros