I know a lot of people are still trying to figure out what is happening in the stock market this week. Whether you have a long or short position already or are just trying to understand what actually went down regarding this week’s hot topics: GameStop, Short Squeezing, WallStreetBets, Melvin Capital, and Robinhood.
First, you need to understand what a short position / 'short' is: when you borrow security (it could be shares of company stock, commodity, ETF, etc.) from a broker and sell it immediately at its current market price. The reason you would do it is that you think the price of the stock is overvalued so you can buy back the stock later on at a lower price, return the shares you borrowed to the broker and then keep the profit.
The stakes are enormous as this is an unprecedented historical event that is happening right now, which is why everyone is talking about it on the internet. At the center of all of this are the gaming retailer, GameStop ($GME), and the Reddit forum /r/WallStreetBets (also called WSB), which is a subreddit where participants discuss stocks and options trading. This event later also are involved more stocks of public traded companies such as the movie theater company AMC Entertainment Holdings, Inc. ($AMC), Nokia Corporation ($NOK), BlackBerry Limited ($BB), Bed Bath & Beyond Inc. ($BBBY), as well as commodity-related stocks like iShare Silver Trust ($SLV), an exchange-traded fund (ETF) that tracks the price performance of silver, and the silver mining company Silver First Majestic Silver Corp. ($AG).
How it all started: some hedge funds figured that GameStop was a struggling business and going to go bankrupt so they short sold the stocks trying to make a profit. These short-sellers shorted over 140% of the float of stares of GameStop, 40% higher than what is available in the market when this story started picking up steam. However, this is not new at all. Many short-sellers have been doing this for a long time. But in the summer of 2020, a few well-known investors noticed this high level of short interest in the market and decided to start buying those stocks in Youtube videos.
A few weeks ago, some traders on WSB noticed the same thing about a hedge fund named Melvin Capital, one of the most known hedge funds that specialize in short selling. Melvin was very successful historically and had taken a massive number of short trades against $GME. They decided to short squeeze these hedge funds by convincing all the readers and subscribers of that subreddit to join forces and buy up as much $GME in the market as possible. There are more than 6.3 million users are subscribed to /r/wallstreetbets as of today and about half of them joined since Wednesday. This has made the price rise which then caused Melvin and many other hedge funds had a short position on $GME to lose billions. Their losses were so large and surpassed $13.1 billion, which was even more than what their fund was worth, nearly forced them to be bankrupt.
Redditors joined forces on Social Media:
Day trading and individual investing have also boomed over the past several months due to more people stay at home and decide to get into trading. Some of these traders are among the millions of traders who collectively joined this force, propelled by a mix of greed and boredom, determined to teach Wall Street a lesson by constantly delivering the message mostly via social media and on the Reddit forum. This army of traders on WSB didn’t just target GameStop, they also picked up other stocks that other hedge funds are shorting hoping to short squeeze them as well. This event has quickly escalated and many people outside Reddit are also starting to join forces and hence, $GME, $AMC, $NOK, $BB, $BBBY, $SLR, and $AG all skyrocketed this week.
People have recently questioned what is going to happen when these hedge funds who shorted these stocks cannot cover their obligations to pay back their loans like what happened to Melvin Capital. Some say if they cannot continue to post collateral with the brokers, these would be assumed by their prime broker. Prime brokers are investment banks who take on risks like this for hedge funds in the event that the hedge fund makes bad trades and needs to liquidate. This was what happened during the 2008 stock market crash, but what is different today is that this risk will be assumed by multiple banks vs. just one on the behalf of one fund previously.
The potential risk and consequences:
Because Melvin was historically very successful and had to turn down many clients. This led to a bunch of other funds who just follow everything that Melvin does and get clients that Melvin doesn’t work with. If Melvin’s risk is spread over to multiple banks acting as prime brokers for them, the risk could potentially is higher than what may seem on the surface. Because there are more hedge funds that follow Melvin’s stock shorting moves, there could be even more banks out there that could have exposure to this risk as well.
Since the price squeezed on the GameStop short sellers is enormous and infinite, this is essentially a money printer for these traders. As the value of thein equity continues to rise, GameStop shareholders are able to even more money against GameStop stock on margin through their brokers. This situation will quickly be escalated to a point where the short sellers cannot cover their positions in GameStop as well as all of their other short positions. It is like that every bank who acts as a prime broker for any short-sellers out there will have exposure to all of this risk eventually. As a result, this could be a risk on the overall investment bank system in the U.S. leading to a stock market crash, just like in 2008.
Robinhood also faces an uncertain future after this week:
GameStop’s stock continues to spike today, with shares jumping an additional 70% early today. Due to this recent continuous spike, Robinhood initially prevented traders from buying more short positions of these short-squeezed stocks on Thursday. Because of this, Robinhood got hit with a class-action lawsuit filed in federal court for this trading halt. This morning the app instead opens limited buys where each customer can only buy one share and up to five options contracts of $GME. If a customer already owns shares of $GME, they won't be able to buy more. The company also expanded its list of restricted stocks from 13 earlier in the day to 50 just right before the markets closed today. Some of these 50 restricted stocks include $AMC, $BB, $SLV, $AG, and even more stable stocks like GM, Ford, Disney, Starbucks, etc. You can find a list of these restricted stocks on their blog here.
Moreover, Robinhood also confirmed that it temporarily has turned off the instant buying feature for cryptocurrencies due to the "extraordinary market conditions" as the price of bitcoin and dogecoin rose sharply today.
If you are looking for a different platform to trade as a replacement for Robinhood, I’ve included a few options below:
Webull: very similar to Robinhood’s features, 0% commissions & fees.
Coinbase: for cryptocurrencies only, very user friendly.
Disclaimer: The information provided above isn’t financial advice. My analysis and personal opinions are presented for entertainment purposes only.