I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy.
— Warren Buffett
First of all /wallstreetbets or short /wsb it a reddit online community of young self-ironic traders. They call themself autistic and usually post big losses and large gains from their investments and other memes. They don’t invest on a sustainable long-term way, they are trading with very large risks and they know it. That’s why they call their trades YOLO trades. But instead of what the most media says, not all of them are complete beginners, a lot of them just gamble with small amounts.
The boom of new easy-to-use trading apps accelerated the growth of the community. But the biggest growth happened in the last week, where a lot of new users joined the community to participate in the short squeeze, reaching 4.6 million users.
GameStop is a struggling, kind of boring, mid-size retailer stuck in a legacy business — selling physical video games. But it’s also pretty much the only company anyone on Wall Street is talking about right now after its stock rose 160% in a matter of hours on Monday morning to an all-time high of $159. (By day’s end, GameStop’s price had been cut by more than half, but that still left it up more than 300% this year and almost 3,000% from its 52-week low. And it was up another 15% at Tuesday’s open.)
But that’s only the beginning. While the stock price rose, hedge funds and other big players started to short GameStop even more. Shorting in general is not necessarily a bad thing. Short sellers profit from overvalued companies or extreme hypes, where they basically sell stocks they don’t own and buy them back later for lower prices. At some point they have to cover their shorts and buy them back. If the price decreased between selling and buying back, they profit.
However, for GameStop the short sellers have been very greedy and managed to sell more than 140% of the available shares short. And that’s the reason for what we see today. The reddit community did research and found out that this situation is unique, and they could use this against the short sellers. So, they started buying GME stocks.
A risky bet — because the short seller has to return the borrowed shares — even if the share price has risen. For companies like Melvin Capital, that means a huge loss. They have to buy the stock more expensively than they sold it.
According to CNBC, Melvin Capital has already closed its position. The fund lost about 30 % from its $12.5 billion in assets². An unbelievable loss, caused by an online community. But what incentive do the YOLO traders have anyway?
GameStop is a bubble. So buying the stock is a big risk — but Reddit users are still risking their money. All for a bit of fun?
On the one hand, there are also financial prospects. If a short seller has sold the borrowed shares but has to return them, he is in trouble. To honor the contract, he has to buy the shares — at whatever price³. The demand that then arises can drive up the price of the shares. This is what many of the Reddit users are hoping for. In many posts, they speculate that the GameStop share could be worth thousands of dollars.
That’s very optimistic — but apart from money, users also care about something else. The example of Melvin Capital shows that it is no longer just a meme — the internet has shown how influential & destructive it can be.
It is important to understand that hedge funds do not invest with their own money. They collect investors’ money to invest. A 30% loss of assets may not sound like a wipeout, but it could have more severe consequences. Ultimately, a hedge fund lives on the trust of its investors.
As a result, confidence in hedge funds could be significantly weakened. Fewer investors would dare to put their money in the hands of others.
As we go through congressional hearings and the public shaming that is likely to come, let’s not lose sight of the truth.
Whether the Reddit events are idiosyncratic or catalyze a more systemic problem is unknown at this time.
However, it is the question that should be answered instead of the virtue-signaling that is going on.
Let’s hope that when investigations are done, and books are written, market participants and regulatory authorities will feel the right actions were taken over the past week — even if that meant certain parties did not get everything they wanted (e.g., unrestrained trading).
If that is the outcome, confidence in the financial markets will be maintained and possibly even enhanced, benefiting the markets, the economy, and the majority of individuals participating in both.