On Friday, January 22nd, the stock price of an off-radar US video game retailer, GameStop, shot up 50%, causing a trading halt in its shares. The stock went up 18% the following Monday and 93% on Tuesday. Suddenly, everyone was talking about GameStop and how a Reddit community, named Wallstreetbets, declared “war” on Wall Street and the “mean” Hedge Funds.
So, what happened?
Days before the events unfolded, Citron Research said GameStop’s business was in “terminal decline” and mentioned it had a short position on the stock. Melvin Capital was also known to be heavily short on GameStop. Both hedge funds, and many others, believed the company was going under and wanted to profit from its decline.
Just to note that “short” or “short selling” is used to speculate that a company’s stock price will decline. In essence, investors borrow a stock and sell it on the open market, aiming to buy it back later at a lower price and capture the difference as profit.
GameStop’s short-selling was so crowded that a surprising 140% of its available shares were sold short.
Going back to our story, Reddit’s Wallstreetbets forum didn’t appreciate the public intervention of Citron and decided to fight back. Leaving 15,000 employees jobless is always a good purpose to fight for, however, there was another angle too. Reddit traders believed that if they could push GameStop’s price up, this could lead to a “short squeeze”, forcing Citron, Melvin and other short-sellers betting against the company’s shares to back out of their bets and cover their positions.
What is a short squeeze?
When a hedge fund has a short position on a stock, there is no limit to how much money it can lose. Even if the short position was initially $1,000, the Hedge Funds can lose an infinite amount of money if the stock price suddenly skyrockets. When it comes to risk management, Hedge Funds are very strict on how much they can afford to lose. So, when the stock price begins to rise, short-sellers are forced to begin buying shares, in order to cover their position and cut down their losses. This, in turn, causes a further rise in the stock price and acts as a self-feeding loop.
So, suddenly, a trending Reddit discussion, an Elon Musk’s tweet and a publicized long position by Michael Burry, the hero of “The Big Short” movie sent GameStop’s stock up by 240% in just 3 trading sessions and more than 1,000% in a month, short-squeezing huge Hedge Funds along the way! Melvin Capital reportedly lost 50% of its value within weeks and had to be bailed out by Citadel and Point72!
It wasn’t long until the frenzy expanded to other stocks, like AMC, Blackberry, Nokia and even silver.
The Gamma squeeze effect.
Although the short squeeze effect has been widely discussed over the past weeks, it’s probably something else that caused the sudden rise of meme stocks’ prices. In fact, short interest on GameStop remained relatively flat during this wild ride.
It was the gamma squeeze. In essence, the gamma squeeze occurs when a large number of call options contracts forces market makers to buy more and more of the underlying stock. When you buy a call option (the option to purchase a share in the future at a pre-determined price), there is a market maker on the other side of the trade who “creates” this contract for you out of thin air and takes the opposite position. You bet against him. However, market makers don’t want to keep that risk on their books, as if the stock’s price skyrockets they would lose a fortune. So, they go to the open markets and buy the underlying stocks, in order to hedge their position.
Reddit traders extensively used call options to bet that GameStop’s price would go up, so, this buying of shares by options’ market makers caused the stock price to further rise, in a similar spiral effect as the short squeeze.
Can this happen with other major stocks?
No. The success of WSB’s story was a combination of 5 different factors:
1. A heavily shorted stock. GameStop’s overall short positions were 140% of its available shares (floating shares). This is a very crowded trade.
2. Low trading volume and small market cap. This means that the sudden effect of some retail traders could be significant and cause sharp rises in the stock’s price. This could never happen with Apple or Amazon.
3. A positive narrative on fundamentals. Apart from Michael Burry, other investors believed and could justify that GameStop was significantly undervalued.
4. Publicity. This would have never become possible if retail traders couldn’t coordinate on Reddit and if Elon Musk and others didn’t spread the word.
5. Access to options. Retail traders can now easily access options. This means that traders with $1,000 in their account can take positions on $1,000,000 worth of stock and multiply their effect.
And then comes Robinhood.
In an unprecedented move, on Thursday, February 28th, Robinhood decided to ban buying of GameStop and 12 other stocks for its users. In fact, Robinhood’s users were able to sell these stocks, but not buy them. At the same time, Hedge Funds were free to trade them in the markets at will!
You may wonder, how can you ban people from buying, but allow them to sell? Who are you selling to? Well, in our case, it was probably the hedge funds who needed to cover their short positions, at a lower price.
This move has been strongly criticized and raised concerns about Robinhood’s incentives and business model. In essence, when asked to pick sides in the “war” between Reddit traders and Hedge Funds, Robinhood decided to protect its customers without a second thought… the Hedge Funds!
It’s a common secret that hedge funds, like Citadel, pay millions to Robinhood for order flow. In simple terms, when you buy a stock using Robinhood, your order never actually reaches a stock exchange. Instead, it is directly sent to big market-makers, who use super-fast computers to profit from tiny price discrepancies within a fraction of a second.
Robinhood makes almost $200 million every quarter from payments for order flow. You can easily guess how much money market-makers are making, to be happy to pay Robinhood huge amounts.
And you can easily guess where is the money coming from… the retail Robinhood trader.
So, there is a saying that perfectly applies to Robinhood’s business model: “If you’re not paying for the product, then you are the product.” Robinhood’s users are the product. Hedge Funds are the customer.
The irony of the flow of capital.
So, if we take a step back, we can see a funny story for the flow of capital on the GameStop events:
After being short-squeezed, Melvin Capital rushed to buy back GameStop’s stocks, in order to cover its shorts. So, Melvin lost over $3.75bn to Reddit traders who were long, either directly or through call options. Reddit traders, in their majority, used Robinhood as their broker. From Robinhood, the order flow was routed to Citadel to be executed. Citadel Securities, acting as a market-maker, obviously makes a lot of money from all these orders. And then Citadel bails out Melvin Capital with a $2 billion additional investment.
Or, from Melvin Capital to Reddit traders, to Robinhood, to Citadel, back to Melvin. With some leaks along the way.
Wealthyhood and the case for the long-term investor.
When the dust settles, the case for the long-term investor will become more prominent than ever before. As of the day of writing, GME is 80% down from its highs. You may have made a lot of money or lost almost all your money if you decided to gamble on meme stocks, alongside Wallstreetbets participants.
Long-term wealth creation doesn’t work like that. It’s more of a marathon, then a sprint. You have to invest periodically and persistently in both rising and falling markets, in order to make it work. Construct a robust portfolio that matches your needs and preferences and stick with it.
In an era where retail investing seems completely derailed, we decided to build Wealthyhood to accommodate the long-term investor in their journey.
Wealthyhood offers a brand new, DIY wealth management experience for younger, long-term investors.
An experience that brings back an investing mentality, rather than frenzy speculation and answers to 3 main concerns:
1. “I have no idea how to invest.”
We bring together hands-on guidance, insights and feedback throughout the whole investing experience.
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We have more than 250,000 pre-made optimised portfolio templates. You can easily pick the right one for you by just answering a few simple questions. And it’s also DIY — you’re on the driving seat, instead of chasing the car.
3. “I don’t want to pay excessive fees for things I can do on my own.”
If your aim is to steadily build your wealth over time, instead of looking for the next GameStop, reading r/wallstreebets and buying call options, then we’re building Wealthyhood for you. You can get early access by signing up to our waiting list here https://wealthyhood.com.
On the positive side:
- It’s great to see that a bunch of retail investors with a few hundred $ in their accounts, access to commission-free investing apps and an online forum have the power to short-squeeze a 10B+ Hedge Fund. In essence, they participate in the market on equal terms.
On the negative side though:
- Trading in such a way enhances herd behaviour. It’s moving when everyone is long against a “mean Hedge Fund”, but it’ll be terrifying when it’s unfolding on a falling stock or market.
- There is huge detachment from fundamentals. People buy stocks because they believe other forum participants will also do. Fundamentals don’t drastically change overnight.
- The worst part: Market participants seem to be treating investors unequally. It seems to be ok when hedge funds use questionable practices to multiply the money of their investors, but it’s “bad for the markets” when there are forced out of their trades by retail investors.
- And the most concerning part: Stock market gambling is becoming the new normal. It’s looking more like a “double or nothing” bet, and nothing to do with investing your money to grow your wealth.