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Reddit Rage Thumbnail

Reddit Rage


US equity markets have had a fascinating January. Underneath a pedestrian 1% decline in the S&P 500 was enormous individual stock volatility and core disruptions in market structure. Over the past week, I have had questions posed to me by my 15-year-old son, a friend in his early 30s, a physician friend in his 50s, and a friend in his 70s, along with many of my colleagues at TrustCore. These questions include why is Gamestop (NYSE-GME) up so much and what is short selling? This question action isn’t a normal week for me and is indicative of what a unique month it has been and the widespread media coverage of the events. It is my suspicion that there are likely many questions out there in the TrustCore client base, so this post will be an effort to explain some of these recent events, put them in context and talk about any impacts to you. I am going to deploy a question-and-answer style and have my 15-year-old and his friend read this to see if it passes muster (lucky them), so hopefully the write up will play to a wide audience.

What happened?

Like any good preacher or teacher, I am going to try and sum up the week’s events in three points.

1. A large social-media-user group, numbering well in excess of two million and growing daily, on Reddit (i.e. a social media platform akin to Twitter) used their collective, decentralized buying power to cause a short squeeze in several stocks. The most notable of these was Gamestop. With strong elements of economic populism to their purposes (aka let’s stick it to the rich billionaire hedge fund guys), these investors are empowered by an unprecedented way to communicate in real time and the zero cost, online, trade anywhere technology of brokerage apps by Robinhood, Square, Schwab, Fidelity and others. The barrier to entry is a smartphone.

2. Many of the stocks targeted for buying were heavily shorted by various hedge funds, most notably the firms Melvin Capital and Maplelane Capital. As the targeted stocks moved ever higher, these hedge funds began to incur massive losses and were forced to cover their positions and deleverage their portfolios. The Wall Street Journal reported this morning that Melvin Capital was down 53% in January and required a significant capital infusion to avoid going out of business.

3. The massive amount of volatility and dollar volume of trading in the targeted stocks brought into question the capital needed by the various brokerage firms to settle and clear trades. Starting mid-week, many brokerage firms most exposed were forced by the main market clearing firm (Depository Trust & Clearing) to post more capital. In response, these brokerage firms began limiting customer’s ability to buy positions in the group of highly active stocks to try and limit their capital exposure. Lacking understanding of this core market structure nuance, the Reddit user group was furious, cried foul and screamed the game is rigged. Politicians of all stripes began to weigh in on the situation saying Wall Street needs reform.

What is short selling?

If you want a pretty easy to follow example of short selling just watch the movie Trading Places. In the climactic scene, the characters played by Dan Aykroyd and Eddie Murphy short frozen concentrated orange juice futures and put the film’s antagonists in the “poor house” to quote Mr. Murphy. In its simplest terms, shorting something is a bet that it’s price will go down. The old adage of “don’t sell me short” is a statement of belief that one won’t fail but succeed. To sell a stock short the following steps happen:

1. Investor A wants to bet that a stock will go down in price. She wants to sell that stock and then buy it back once the price has declined in order to make a profit. To sell a stock, she needs to borrow a share(s) in that stock from Investor B so that she has something to sell. Investor B is willing to loan share(s) in the stock to Investor A in return for interest income and a promise to return the borrowed shares in the future. Investor A with borrowed stock in hand is now ready to go to market and short sell the stock.

2. Fast forward in time, the stock has gone down as Investor A hoped and she is ready to close out the trade, commonly called covering her position. To do this, she must go out and buy share(s) in the market in order to have the stock to repay her loan from Investor B. The difference between what she sold the stock for less what it cost her to buy it back and less her interest cost on the stock loan nets out to her profit on the trade.

Exhibit 1: Basics of a Short Sale

Now that is how a winning short trade works out. What happens if the stock price doesn’t cooperate with Investor A’s wishes and goes up instead of down? In that case, things can get painful really quick. Unlike simply owning a stock where all you can lose is the capital you invested, in a short trade your potential loss is unlimited. For example, if you short a stock at $100 and it goes to $1,000 and you covered there, you lose $900.

In the month of January, Gamestop went from $17 to $483 … imagine being short that … if Investor A had sold $10,000 of Gamestop short on January 1 and not covered, she would have a $274,000 loss at the stock’s high price on January 28th. There aren’t many investors who can withstand this sort of loss without going bankrupt and so there becomes a rush to cover their short position as the price begins to go up and the result is what is called a short squeeze where a stock goes up exponentially in a short period of time as those short rush to cover their positions.

Exhibit 2: One-Month Chart of Gamestop

How do hedge funds fit into last week’s equation?

Prior to my role as CEO of TrustCore, I was portfolio manager with two different long-short equity hedge funds. The business model of a long-short hedge fund is to raise capital from investors and then invest that capital across a range of securities, some long that the hedge fund hopes to go up in price and some short that they hope to go down in price. Hedge funds get paid a management fee (typically 1% of assets) and they take a cut of the investment gains (typically 20%). This can be lucrative gig.

A very questionable financial innovation of the last 20 years is the introduction of leverage to the hedge-fund model. Many hedge funds borrow capital from banks to increase the amount of capital that they can invest (the firms I worked for never did this). For example, Hedge Fund A raises $1 billion from its investors and then goes to a collection of banks and borrows an additional $4 billion … Hedge Fund A now has $5 billion to invest. The premise on this is that in being long and short the risk to the portfolio and the lender is lower as broader market risk exposures are paired off against one another via long and short positions. This is all great in theory, but if Hedge Fund A experiences short squeezes in a large number of its short positions, then the leverage that it has deployed to its portfolio can really start to bite. This is how a firm like Melvin Capital can be down 56% in a month where the S&P 500 is only down 1% -- the Reddit gang targeted a large number of its short positions, ran up the price, started short squeezes and the leverage Melvin Capital had deployed magnified the losses. To put a fine point on this example, if Melvin Capital were Fund A from example above and had a 1% short position in Gamestop ($5 billion * 1% = $50 million initial short position) and didn’t cover that position in January as the price ran up they would have an unrealized loss of $1.4 billion … you can see how they got motivated very quickly to cover.

What about the Reddit gang? Is this the new investing paradigm?

It is hard to know what to think of the Reddit gang. The group’s founder is a guy who goes by the name of Roaring Kitty. To date, their strategy is to target a bunch of heavily shorted stocks … this collection of companies could really be nominated for the bad business model hall of fame (Gamestop, Blackberry, AMC Theaters, etc.). This group appears to be motivated by equal parts of greed and populism (i.e. the idea of sticking it to the proverbial man). The group doesn’t appear to be doing any real fundamental investment analysis and their biggest advantage appears to be strength in numbers. At the outset, their strategy has worked well … the little guy has taken down the big hedge fund. Time will tell if this sustains, but I think what is old is new. The book Extraordinary Popular Delusions and the Madness of Crowds lays out centuries of irrational financial behavior. If someone chooses to do an update of that book, the events of the last month could be an interesting new chapter. There is nothing new under the sun.

What does any of this mean to you?

  • This current episode has not fully played out so one impact may simply be increased market volatility over the coming weeks. We counsel our clients to try and take this volatility in stride with the persistent adage that time in the market is more important than timing the market. We build diversified, unlevered portfolios for clients and so we believe this helps mitigate the risks from events like this to you. One likely scenario is a new firm like Robinhood could continue to face trouble as its customer base takes its business elsewhere as retribution for the inability to trade in its favored stocks. We would also welcome reform that makes hedge fund leverage like what Melvin Capital deployed illegal.
  • I think the events of the last month and year have made the case for the value of working with an advisor that can be a counterbalance to our base emotions. Money is an emotional thing and humans have an innate tendency toward irrationality about financial matters. Part of our jobs at TrustCore is to be a guide, coach and counselor to our clients through the emotions of financial decisions. We can help you see through common pitfalls like anchoring, loss aversion, hindsight bias, and others leading you to better outcomes. Left to our own devices we can gravitate toward either taking no risk or joining the mob on Reddit.

I have likely written too much so I will stop here. I hope this has been helpful to you. As always reach out to your advisor with any questions or comments or feel free to email me directly at gary.dean@trustcore.com.

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