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Social media dictates every facet of our lives today, including trading the financial markets. Plus, we are witnessing massive transformation in the markets, driven by the combination of technology, finance and democracy. This is a new era of financial participation and market dynamics. But rarely does an event in the stock market cross over into the cultural mainstream. When that happens (like it did in the 2008 crisis), it signifies a huge and catastrophic financial event. What started as a social media discussion, led to one of the biggest short squeeze events in the US stock market.
In January 2021, an obscure event defied all market logic and risk management protocols. A swarm of retail investors on Reddit managed to trigger the biggest short squeeze event in 25 years in the US stock market. What is a short squeeze? And how did it happen? Let’s take a look.
GameStop, a retail store chain that sells video games in the US, had a tough year during the pandemic. Like scores of other companies, it suffered from the sudden and massive shift in consumer purchasing trends, towards online shopping. As a result, Wall Street investors started betting heavily against it.
For instance, Melvin Capital, a huge hedge fund company, had massive short-selling positions on GME shares. In December 2020, GameStop’s shares were trading at around $15.
Image source: https://www.thegamer.com/gamestop-stonk-stock-memes/
However, a Reddit community named r/wallstreetbets had started a discussion on the group some months ago, on how these stocks were vastly undervalued. On January 11, 2021, the company announced new board members to help with its digital sales strategy. This caused an uproar on the group. Eventually, the discussion went viral and many retail traders bought into GME stock, propelling its market value significantly. In the last week of January alone, the stock spiked 400% and more than 1,600% over the whole month.
This caused a short squeeze situation in the market.
A situation where the price of a stock (or any other asset) rises to such an extent that traders who had predicted that its price would fall ultimately have to buy it, in order to prevent further losses, is technically a short squeeze.
GameStop’s share price surge was particularly bad for Melvin Capital. The group had $55 million worth of put options on the stock. A put option is a derivative instrument that gives owners the option to sell a stock at a certain price at a future date, backed by the prediction that price will go down. The meteoric rise in price of GME made these options worthless. Melvin Capital now had to purchase these shares at their inflated price, only to return them to their original owner.
The company took a $2.75 billion bailout, but had to eventually close out its short, which added to the rally. The company lost 53% in January alone.
Another stock that institutional investors were betting against was AMC Entertainment Holdings Inc. The Reddit community r/wallstreetbets again proved that it is an investor force, targeting assets and pushing their prices up.
Image source: https://twitter.com/dannyvegito/status/1354562663053991947
AMC’s stock price was pushed so high that the company was able to wipe out $600 million in debt from its books. A similar agenda (#SilverSqueeze Manifesto) was also pushed against silver, citing that big banks, investment firms and governments have been manipulating silver prices for decades.
In a span of just one week, the price of silver rose 20%, briefly touching an 8-year high of $30.03/oz.
However, some analysts believe that the funds that shorted GME shares were actually holders of the biggest long positions in silver. Silver was actually not pushed by the Reddit message board but propagated by the media.
Traders have come to realise that short squeezing in the commodity markets is a difficult task. Precious metals like silver are part of a globally deep market, and unlike stocks, it is highly difficult to create an effective short squeeze in them.
What goes steeply up in the markets often crashes even harder. GameStop’s shares closed down 65% on February 3, 2020, and AMC had lost 26%, while Silver declined 5% after a record high. Experts maintain that a long-term price rally, due to social media driven theories, cannot be sustainable.
It has also attracted intense scrutiny from regulatory bodies like the US Securities and Exchange Commission (SEC), which is now closely monitoring the conduct of financial intermediaries and potential market manipulation. The Australian Financial Watchdog, ASIC, is also monitoring the silver markets. Not just traders and brokers, the regulatory bodies are also monitoring big hedge funds that might be short selling more than the “float,” stocks actually in circulation on exchanges.
At a macro level, this brings forth the indirect impact of near zero-cost funding in the ultra-low interest rate environment being maintained by the central banks. This creates asset price bubbles, just like GameStop. These aberrational moments happen time and again, and it’s not so long ago that we saw the consequences of these actions with the 2008 financial crisis.
What is also evident is how much power retail traders can now exert. While in the past, institutional traders were the ones who could move markets, today, retail traders can do the same. As per a new report by the FINRA Investor Education Foundation (FINRA Foundation) and NORC, at the University of Chicago, the global pandemic led to an influx of new and experienced retail traders into the stock markets. Over 38% of new and young investors were those who opened non-retirement investment accounts in 2020, 19% were experienced traders.
This is because market dips made stocks cheaper to trade and the barriers to entry declined, allowing traders to start off with a small amount of capital. Research has proven that given an opportunity, investors will trade stocks, due to historically higher long-term returns in this market.
Even the Reddit subgroup, wallstreetbets, a hub of relatively young amateur traders, saw a huge spike in activities in the pandemic. As per subreddit stats, the group had 450,000 members in January 2019, which increased to 774,000 members in January 2020.
The GameStop event proves that together, retail traders can wreak havoc on the financial markets now. News, memes and personal anecdotes can push people to trade in a particular direction. It also puts light on a theory that the stock markets are completely disengaged from reality.
Entrepreneur Mark Cuban has warned of the dangerous consequences of this power. Just because people lost money might not stop them from participating in a mad frenzy again.
This increases the importance of risk management in all types of financial trading. Irresponsible trading from any part of the community, hedge funds, experienced or new traders, will impact asset classes.
Image source: https://www.thegamer.com/gamestop-stonk-stock-memes/
Esquire, Business Insider, MarketWatch, Investors.
