The financial story of the year to date is how a mob of small-fry retail investors worked together to put a legendary short squeeze on major hedge funds, almost bringing them to their knees. Amid the hysteria, here are some truths.
The story of how an army of retail investors buying Gamestop shares put the squeeze on hedge funds who had been heavily shorting the stock, has been cast as an uplifting David versus Goliath story.
Like any story, however, a lot of nuance is needed to really understand what happened, what misconceptions abound, and what the implications are. I’m no investment guru, but here is my understanding of this complex yet exciting story.
Gamestop is an American bricks-and-mortar retailer of computer games. It occupies a treasured place in the hearts of many gamers, who recall it with the same sort of nostalgic fondness that South African music lovers held for the lately deceased Musica record store chain.
Listed in 2002, its stock peaked at an all-time-high of $63.68 on the day before Christmas in 2007. It reached a second peak in the high-50s in 2013, but since then, as games are increasingly sold online, it has been downhill all the way to its all-time-low of $2.57 on 3 April 2020. It seemed that the Covid-19 lockdowns would be the final coup de grâce for Gamestop.
Hedge funds
Unlike most investors, hedge funds have ways to profit from this sorry state of affairs.
Ordinary investment firms such as mutual funds and exchange-traded funds manage money on behalf of ordinary retail investors. Hedge funds, by contrast, have only institutional investors and high-net-worth individuals as clients. Because of the presumed financial sophistication of their client base, they are far less strictly regulated in terms of the risks they are permitted to take.
To maximise ‘alpha’, or the margin by which a fund beats the general market, hedge fund managers deploy aggressive and complex investment techniques. At issue in this story is a strategy known as short selling.
Ordinary retail investors typically buy shares, in the hope that those shares will appreciate in value. That’s called ‘going long’ on a stock. The maximum risk to which such an investor is exposed is the total value of their investment, since the share price can, at worst, go to zero.
When you believe a share will instead depreciate in value, you could ‘sell short’ by borrowing the share from a market-maker and selling it at the current price, on condition that within a given time limit you are required to repurchase the share on the open market and return it to the market-maker.
If the share did depreciate, your trade is in the money. If, instead, it increased in value, you’re out of luck. You still have to buy the share to return it to the lender, so you lose money on the trade.
Because there is no upper limit to a share price, the risk to a short seller is also unlimited. If you borrowed and sold a share for $20, in the hope that you could at the close of the contract repurchase it for $15 and make $5 profit, but instead the share price spikes to $100, you’re now in the hole for $80.
This makes short selling a high-risk investment strategy that is heavily regulated. It is widely employed by hedge funds, however, and hedge funds were short on Gamestop. Heavily short. So short, in fact, that there wouldn’t be enough Gamestop shares available to cover all the short positions.
This situation is often blamed on what is called ‘naked short selling’, when the share being shorted is not actually available for delivery. This practice is highly controversial, and illegal in many jurisdictions. It can also happen without naked shorting, however, simply because a short-seller can borrow the share from a short-buyer, and short it again. There is no theoretical limit to the number of times a single share can be shorted.
Enter Reddit
Some hedge funds treated Gamestop like a one-way bet, believing it could only go down in the medium to long term. Then a Redditor who goes under the moniker DeepF***ingValue (DFV) entered the party.
Back in 2019, DFV had bought $40 000 worth of Gamestop shares. Despite earnings reports that were described as ‘nightmarish’, he believed that the company did not deserve to go under and could be turned around by new management.
He explained his trade on WallStreetBets (WSB), a forum on social news site Reddit where retail investors and wannabe day traders share stock tips and investment strategies.
For the most part, WallStreetBets is filled with memes and so-called ‘loss porn’, as people describe fateful stock bets gone wrong. Not this time, though. Since its all-time-low of $2.57 in April 2020, Gamestop shares slowly recovered, first to around $5 by August, then to $15 in October, and to $21 on 28 December 2020.
Influential investors like Michael Burry, who was played by Christian Bale in the 2015 movie The Big Short, and Ryan Cohen, co-founder of an e-commerce company, disclosed that they had taken big stakes in Gamestop. Cohen went on to get a seat on the board, which was widely seen as a positive development for the company.
Throughout, DFV posted updates on his trading position in Gamestop, first as his investment doubled in value before crashing again, and then steadily appreciating into the millions towards the end of 2020. He labelled these posts YOLO, for ‘you only live once’.
By the end of January, his portfolio was worth just shy of $50 million – more than a thousand-fold gain on his original investment. Reportedly, he has cashed out about half of that already, which will become important later in the story.
Short squeeze
This turn in fortunes for the Gamestop share price was really bad news for short sellers, of course, who still held shorts worth 139% of Gamestop total available stock in December.
By 13 January 2021, trade volumes started picking up and the share went to around $40. On 22 January, Citron Research put out a video detailing their short strategy. This provoked a backlash from gamers who loved the store, so severe that the company deleted its video.
Prodded by DFV’s regular updates of his YOLO bet on Gamestop over on WSB, people started piling into the stock. Being a small-cap stock with low liquidity that was heavily shorted, the price now really took off.
By 25 January, a hedge fund called Melvin Capital was $3 billion in the red on its short position, representing a quarter of its assets under management. It was bailed out by two other hedge funds, Point 72 and Citadel, who invested $2.75 billion into Melvin Capital to recapitalise it.
On 26 January, the share closed at $147.98. On 27 January, several big-name investors and venture-capitalists, including Elon Musk, tweeted about Gamestop, driving the frenzy even higher, with the share closing at $347.51, having peaked at $380 in intra-day trade. Early on 28 January, the price briefly peaked over $400.
Melvin Capital managed to close its short positions that day, taking a massive loss in the process. Citron Research let it be known that they were exiting the short business for good. However, other hedge funds remained on the hook for many, many billions.
If you’re a short seller and you find yourself in a position such as this, you have the option of extending your short contract, in the hope that the price will crash before you need to repurchase your shorted shares.
To do so, you pay interest to the market-maker from whom you borrowed the stock. That interest is directly linked to the value of the share, however, so these costs can accumulate pretty quickly. Hedge funds can only afford to do so for as long as they have liquid assets to pump into supporting their shorts.
If the broker from which the short-seller borrowed becomes worried that they might not get the share back, they can make a ‘margin call’ upon the short-seller, which is to demand delivery of the borrowed share. This forces the short seller to buy the share at whatever price the market is willing to offer. This can make the fund go bang quite spectacularly.
In principle, those who own the shares, could hold out for a long time. As short sellers become more and more desperate, they’ll keep bidding up the price, to the moon and beyond. The idea on WSB is to get everyone to hold until the share price hits $69 420, which is a rather juvenile symbolic number referring to sex and drugs. They won’t succeed, but if they did, it would rock the markets to their foundations – a prospect which no doubt thrills the Reddit trolls.
Robinhood
Many retail investors who went long on the share did so using a mobile trading app called Robinhood. It was one among several brokers who suspended share buying on Thursday 28 January. This caused the share price to crash to below $200 by close of trading.
The retail investors of WSB exploded with anger, accusing Robinhood of market manipulation designed to protect the hedge funds.
The true reason was more mundane, however. There was no privileged information upon which Robinhood, or anyone else, was trading, so the question of market manipulation doesn’t even arise.
Robinhood simply ran out of liquidity. To execute trades, brokers have to post cash deposits with clearing houses, to cover the credit risk between when trades are made, and when they are paid for, typically two days later. The more volatile a stock is, the higher the clearing deposit.
Because of new regulations designed to protect the financial system after the financial crisis of 2008, they can only do this with their own cash, not with their clients’ cash, and they simply didn’t have enough of it. So it couldn’t execute any more buy orders on Gamestop shares. Retail investors who wanted to get on the bandwagon but couldn’t only have over-regulation of the market to blame.
Predatory financiers
This whole saga is very entertaining. Of course, nobody has any sympathy for hedge funds. They are widely viewed as predatory financiers who delight in making profits by destroying companies. Their role in the 2008 financial crisis has not been forgotten.
Yet the idea that this is a case of justice served upon an evil Goliath by an army of saintly Davids is a little simplistic.
Although retail investors associated with WSB do own a significant stake in Gamestop now, the vast majority of the shares are owned by institutional investors. The WSB crowd might be egging each other on to squeeze the short-selling hedge funds until they reach their sky-high target price, but there is little chance that institutional investors won’t have a much earlier exit strategy.
Many of the retail investors who piled into Gamestop are going to lose their shirts. DFV has already liquidated much of his position and is set for life. Once institutional investors begin to sell, however, the bubble will pop and retail investors will be left trying to catch a falling knife hours, or days, later.
Apps like Robinhood have also come under fire for ‘gamifying’ investing, and underplaying the risks that retail investors take on by trading stocks. Stock trading isn’t a game. If you don’t know what you’re doing, it’s nothing more than gambling. It can have grave consequences, up to and including suicide.
There are many stories on WSB of people who literally bet the farm on Gamestop. This is absurdly stupid. If these investors don’t time their exit perfectly, they will be left holding the bag. Most likely have no exit strategy at all. When DFV was asked about his exit strategy, he casually shot back: ‘What is an exit strategy?’
Expect heart-rending lessons in what happens when you speculate with money you cannot afford to lose.
Capital (mis-)allocation
There is much in this story that is reminiscent of the dot-com boom and bust. Easy money, and in this case trillions in newly printed cash distributed as Covid-related stimulus funds, finds its way into assets, including stocks. This blows up stock market bubbles, which inevitably burst. In the crash, a lot of ignorant speculators get burnt.
The retail raid on hedge funds is no longer limited to Gamestop. Many investors have identified other stocks they believe to be over-shorted and amassed long positions in order to raise the price and squeeze the short sellers.
Often there is no basis for supporting these companies. Blackberry, for example, once was a successful smartphone maker, but was overtaken by Apple, Google, Samsung, and other more innovative firms. It now limps along as a vendor of security software, and its stock has been in the doldrums since 2012, reaching a 17-year low of $3.22 in March 2020.
Like Gamestop, Blackberry was also heavily shorted, and on the back of the short-squeeze mania, its price spiked to $25. This was enough to prompt the company’s executives to dump their stock. Clearly, they have a lot less faith in their own company than the army of retail investors that rode in to rescue them from the evil hedge funds.
The short squeeze has forced hedge funds to sell some of their long positions, in order to cover their shorts, so previously favoured stocks are now tanking while unfavoured stocks are rallying.
It is far from clear that this is a good thing. Most unfavoured stocks are unfavoured for a reason, and likewise with favoured stocks. Capital should, ideally, have a tendency to flow from companies with poor prospects to companies with better expectations.
The fundamentals don’t change overnight, so the retail raiders that are behind this volatility in the market are distorting prices and causing misallocation of capital.
Gamestop does not expect to make a profit until 2023, if ever. It is, essentially, bankrupt. Even if it survives by reinventing itself, there is simply no way the company is really worth $400 a share, for example, let alone $69 420.
That capital should be allocated to far more deserving companies, and hedge fund managers knew this.
David wasn’t the good guy
It should be remembered that when David slew Goliath, Goliath was defending the homeland of the Philistines against an aggressive invasion by the Israelites, supposedly acting on the orders of a God the Philistines did not recognise. It might be satisfying to see the underdog win, but that doesn’t make the underdog right.
Although hedge funds do sometimes take risks they cannot afford, they are no less influenced by easy money than anyone else. Their excesses have a lot more to do with monetary and fiscal policy than with an inherent tendency to take on unsustainable risk. After all, they are motivated to maximise value for their clients, not destroy their wealth.
Hedge funds do serve useful functions in the market.
They provide liquidity. They mitigate market volatility. They far more often take long positions than short positions, so in general, they profit more from rising markets than falling markets.
Short positions, as we have seen, are far more risky than long positions, so no hedge fund enters them lightly. They get demonised for their shorts, but usually by the underperforming executives of companies that miss earning targets and destroy value, or by shareholders that didn’t bail from such companies early enough.
While governments love to try to control markets in the wake of crises, real or perceived, they more often than not introduce more uncertainty, not less. Hedge funds are often the only funds in the market capable of responding to this uncertainty.
They are often the first to detect excessive risks in markets and trade to mitigate (hedge) those risks. Their strategies can go wrong, but they are often innovative and lead to more efficient allocation of capital.
The Gamestop saga is not a well-deserved come-uppance for financial master-manipulators who delight in destroying promising companies.
It demonstrates that even large funds are not immune to wider market sentiment. It demonstrates that monetary policy that drowns the market in cash leads to excessive risk-taking, which can cause unsophisticated retail investors to bet – and lose – everything. It demonstrates that much as large firms can be accused of collusion, small retail investors too can collude to manipulate stock prices.
The most worrying aspect of this story, however, is the likelihood that it will lead to even more regulation of an already over-regulated financial industry.
If governments want to limit excessive risk-taking, perhaps they shouldn’t be showering everyone in free cash with which to gamble in the first place.
The views of the writer are not necessarily the views of the Daily Friend or the IRR
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