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Reddit roulette

The latest shorting drama is about more than a simple David-and-Goliath battle between retail and institutional investors.
Retail traders who hold onto their stock will likely also become losers in this emerging cat-and-mouse game. Image: Tiffany Hagler-Geard, Bloomberg

The battle between retail investors and institutional investors is making headlines as the former take on the Wall Street establishment, in particular established hedge fund managers practising a short-selling strategy.

Ostensibly a David and Goliath battle, the reality is a little more complex.

The heat was turned up earlier last month when a group of investors on a Reddit community called WallStreetBets began to buy up shares of GameStop, a struggling US-based video game retailer when word got out that hedge fund managers were shorting the stock, in other words, betting on a fall in GameStop’s share price.

Read: ‘Game over’ for hedge fund

Short selling is an investment strategy that is used by traders who have identified a company’s shares that they believe will depreciate in value. The trader ‘borrows’ the share from a market-maker and sells it at the current price with the agreement that they will repurchase the share within a particular time period, and return it to the market-maker. The short-seller makes money if the share depreciates in value – but loses money if the share appreciates in value.

Short squeeze

Reddit’s traders took a different view to the short-sellers as far as GameStop was concerned, with the result that since January 11, its shares have risen 1 800%, forcing short-sellers to buy back shares in order to cover their losing position – an action which, ironically, has further boosted GameStop’s share price; a condition known as a short squeeze.

Last week GameStop was the most traded share globally.

That is, until a number of brokerages, including the free trading app Robinhood, stopped the party when they suspended trading of GameStop.

There was an immediate outcry and furious social media backlash, particularly from traders who use Robinhood, a brand built on democratising investing.

The reality, however, is that the app was technically required to suspend trading given that it had run out of liquidity. According to regulations enacted after the 2008 financial crisis, brokers need to have sufficient liquidity to cover the credit risk between the time that trades are made and the time they are paid for. Robinhood was forced to draw down lines of credit worth half a billion dollars to ensure it had sufficient liquidity to meet its clearing deposit requirements.

Relative value

As commentators around the world have pointed out, the surge in the price of GameStop’s stocks has very little to do with the underlying fundamentals and the strength of the business. As a bricks and mortar retailer GameStop urgently needs to go digital, something that it has been slow to adopt.

However, even if the stock may have been undervalued, nobody believes its current stock prices are justified.

The reality is that the GameStop bubble will burst at some point and those investors who are still invested on the long side will suffer losses.

The retail traders buying up the shares, however, have vowed to hold on to their stocks in order to force short-sellers to pay handsomely to cover their losses. However, short-sellers are not the only investors taking risk.

Institutional investors also hold a significant amount of GameStop stock and most of them will have an exit strategy. Those retail traders that have vowed to hold onto their stock and don’t have an exit strategy in place will likely also be big losers in what is becoming something of a cat-and-mouse game.

Retail traders have identified other stocks targeted by short-sellers, including Blackberry, AMC and Nokia where they have been following a similar strategy to raise the price of the stocks and squeeze the short-sellers.

Other shares targeted

South African trading platform EasyEquities informed its clients on Tuesday that they are not able to buy Nokia shares after its US broker-dealer said they would no longer support buys of the Finnish cellphone manufacturer’s shares.

Reddit traders also appear to be targeting Steinhoff. Its share price has seen significant growth in the past week.

The attention of Reddit traders also recently shifted to silver, with silver futures surging to their highest level in years, breaking $30 an ounce, although there is some debate about exactly who prompted Reddit investors to buy up silver stock.

Read: Silver spikes as retail investors swarm their biggest target yet

The GameStop/Reddit development raises a number of issues.

Freedom vs regulation

One aspect is the freedom to express and organise oneself however one chooses – a constitutionally enshrined right in the US – even if that is to wildly bid up the price of stocks. The other issue relates to the ability to limit this freedom through regulation. The US Securities and Exchange Commission, where this drama played out, has a role to play here in ensuring that things don’t get completely out of hand.

Another issue this issue raises is the value of properly functioning capital markets, specifically the aspects of capital raising and price discovery. Certain companies and traders have been able to sell shares at vastly inflated prices.

At some point price will reflect value by which time wealth will already have moved from one set of hands to another.

What about the actions of short-sellers and, by extension, the role of hedge funds that deploy these types of strategies? The question of whether their behaviour is a natural aspect of price discovery or if they have just had their come-uppance, remains unanswered.

Trends

There are a number of trends becoming apparent as a result of the GameStop/Reddit drama. Clearly populism has come to play a role on Wall Street; echoing the Occupy Wall Street theme.

Pent-up frustrations at the financial services industry are starting to become more apparent, making it increasingly likely that the broader trend around the democratisation of finance is likely to persist.

The irony of the WallStreetBets investors is that they are essentially propping up firms that are likely to see their demise in the not-too-distant future unless they take dramatic action. For now, while they have the support of the WallStreetBets investors, a bubble is created.

But as history has shown, bubbles never last. After the highs of last week, GameStop shares are down 80% this week, indicating that the bubble is starting to burst.

I don’t believe that this latest market trend should result in increased regulation.

If investors chose to push the limits then they need to bear the consequences. I don’t believe what’s going on is any one party taking advantage – informational or otherwise – of another.

Paul Marais is MD at NFB Asset Management.

COMMENTS   7

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A member of the public who comes to the market with his preconceived ideas, his gripes and personal agendas and tries to teach lessons to sophisticated investors and traders will pay dearly for his stupidity.

The market does not care about you political views, your beliefs, attitude or mindset. The market simply follows the money, and banks, pension funds and sovereign wealth funds have the money. To fight them is financial suicide.

Yes and no… Because if they get enough of a little group together then screw WS in my opinion.

How are they allowed to do what they did in 2007/8 – and then get bail outs, but Reddit users can’t do it back?

Unfortunately what everyone seems to have forgotten is that there’s an actual company behind the stock, trying to operate and provide goods/services. It isn’t sustainable.

Personally I wouldn’t do this as it isn’t “investing”, but trading or gambling… But power to them if they want to.

If one browses the latest posts on WallStreetBets, they are convinced that the short squeeze is yet to truly peak and this is just a temporary dip. Either they know something we don’t or it’s just a bunch of sore losers.

I understood that the unwashed masses got clever and bought short dated slightly out the money call options. So say share is $100 then $110 dated a month out. So very cheap probably $1 or $2. They bet that $2 with no expectation of exercising or getting the $2 back.

The market maker that sold them the option then buys actual stock to cover the position and THAT is what drove up the price.

I don’t think the masses bought millions of shares?

Hi Johan,

Agree. However, the premiums the optipns have been sky high for months on GME due to Michael Bury interest since April 2019 and Ryan Cohen intro in September and his emoji tweets.

There was accumulation based on his Cheey exploits. People don’t realize that GameStop is a vial le long term business. Shorts just got lazy. Amazon Talent poached last week for CTO.

E-commerce business grew 300%. Buy this is below $30 and it will trade at tech multiples in 3 years.

That is the insanity : why should a retailer selling on internet have a tech multiple at all? It is still just retail, only with different operating expenses.

I like that a group is taking on WS, but ultimately there are going to be some big losers here.

When it’s totally divorced from the reality of the business (e.g. actual value and dividends) then it’s essentially gambling that someone else out there will buy your share for more than you did.
And clearly that has an ending somewhere… And when it crashed whoever is left holding the shares (e.g half the Reddit users) will lose everything they put in.

End of comments.

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