Gamestop and the Reddit crowd-sourced attack on shorting hedge funds: what’s going on and why?

by Jonathan Adams

You’ve probably heard about it in the news. A millions-strong crowd of members of a Reddit community, subreddit r/WallStreetBets, has been working together to drive up the share price of Gamestop, a slightly old-fashioned video games retailer. Gamestop’s market value surged by up to 1000% at points last week.

The community has been coordinating taking out long positions on the Gamestop stock throughout the past week. some actually buying shares but most taking derivate positions via contracts-for-distance (CFDs),

The result has been trading of the stock, and several others including Blackberry and Nokia being targeted in a similar way, being suspended by a handful of retail investment platforms and apps. Most controversially Robinhood, the low-cost fintech trading app.

The bans have caused outrage. The Reddit crowd, and many more who sympathise with their motivations, accuse Robinhood and others such as Charles Schwab and Interactive Brokers who took the same step, of protecting the financial establishment. By doing so, they stand accused of market interference and bowing to the established powerbrokers.

The Robinhood app has encouraged millions of younger investors to take an interest in financial markets and start to dabble in investing and trading. It’s popularity with millennial retail investors was based on a combination of low costs, small minimum stakes, intuitive ‘usability’ and ‘gamification’.

But the consensus view is becoming that the fintech app last week abandoned its stated principles of empowering small investors and hung its user base out to dry by bowing to pressure from its own major investors – the kind of financial institutions being hurt by the crowd-sourced price surges of the Gamestop and other stocks.

Hedge funds holding ‘short’ positions in Gamestop, Nokia, Blackberry and the other stocks being targeted by the WallStreetBets group have suffered heavy losses as a result of the crowd-sourced force driving the price up.

What’s a short trading position?

A ‘short’ trading position is a bet on the share price of a public company falling. But hedge funds staging ‘short’ attacks on companies are often accused of predatory behaviour that destroys businesses. Because these funds control billions of dollars, and often take short bets on stocks worth tens or even hundreds of millions of dollars, their shorting activity can drive the share price of struggling companies into the dirt.

Why are hedge funds with short positions on struggling companies often painted as the villain?

Because a rock-bottom share price makes it next to impossible for these companies to subsequently raise either further equity or debt funding at terms that are commercially viable, sustained shorting by hedge funds can finish them off. The same hedge funds, or others, often then pick the carcass by acquiring remaining assets of value at rock-bottom prices.

And why the hedge funds argue they perform a positive role in financial markets

The shorting hedge funds themselves explain their role in financial markets very differently. They argue that they only take short positions in companies they feel are overvalued by the market. By doing so, they alert other investors to their shortcomings, allowing them to sell while there’s still time.

Yes, they have a financial incentive if other investors indeed take fright and head for the exit by selling their shares. That pushes the shorted company’s share price down, meaning the short finishes ‘in the money’. Win-win, say the hedge funds. They make money, the attention of investors is drawn to why they should have already sold their stock anyway, and the overall quality of publicly-listed companies is maintained. The weak are picked off, making space for new arrivals with far better long-term prospects and potential to grow.

In the financial market ecosystem, shorting hedge funds are the predators. But like in an organic ecosystem, their role is vital to maintaining equilibrium by enforcing a ‘survival-of-the-fittest’ reality. Without them, the ecosystem would be gradually degraded by overpopulation and a weaker ‘gene-pool’ among the prey.

Why are the WallStreetBets subreddit crowd targeting hedge funds?

It would appear to be a mistake to assume the Reddit crowd that have managed to cause such organised chaos in the world’s biggest and most liquid stock market are a bunch of amateurs. Or that a self-interested leadership group is manipulating a gullible crowd into funding huge ‘pump and dump’ moves that they are profiting handsomely from.

Which isn’t to say there isn’t an element of that. It would be naïve to presume some of the Reddit crowd haven’t broken ranks to bank profits rather than sticking loyally to the cause of pushing the targeted stock prices as high as possible. The group is 4.9 million strong (1 million of those have joined in the past week). Human nature means a certain number exploiting the movement to cash in are inevitable in the context of those numbers.

But a large majority are proving themselves to be remarkably disciplined to the cause, sticking to the #HoldTheLine commands coming through Twitter. It’s only through that tight discipline that the group has succeeded.

Their tactic is based on building up enough ‘long’ activity on a stock to squeeze investors shorting it to the point they are forced to cut-their losses and take the loss. That releases the shares they’ve borrowed to short back onto the market, at the higher market price.

To keep driving the price further up, more of the crowd have to keep taking longer positions at ever higher price. That continues to ‘squeeze’ more and more of the traders holding short positions. The Reddit crowd are working together, and taking on significant personal financial risk in doing so, to push the price up to a point almost all of the hedge funds holding short positions are forced to sell and crystalise losses.

For it all to be tied up in a neat way that doesn’t see many of the WallStreetBets traders take losses, they also have to coordinate the closing of their long positions. Achieving that level of disciplined coordination between so many individuals, each with their own self-interest to break rank, is what is most remarkable about the entire episode. Especially in light of the fact the vast majority either don’t know each other or only in the context of the subreddit – an online forum.

What exactly is the WallStreetBets cause?

Ironically, against the backdrop of Robinhood’s PR fiasco in banning trading of the stocks being targeted by the Reddit crowd, the WallStreetBets group’s cause is, roughly summed up, to stick it to the hedge funds. While conveniently profiting at the same time. Taking from the rich to give to themselves.

They see the hedge funds as fair game. Immensely wealthy financial institutions who kill off companies and livelihoods for a living by shorting them out of viability. Live by the sword, die by the sword, say the WallStreetBets crowd. The hedge funds are getting a taste of their own medicine and it’s the ‘man or woman on the street’ giving it to them.

Does this mean the end of shorting? Have the hedge funds been hobbled for good?

Even if a number of popular trading platforms have banned trading of shorted stocks being targeted by the WallStreetBets crowd, they haven’t, and won’t, all do so. Unless the crowd’s behaviour is officially declared market manipulation.

That, I personally think, is unlikely due to the controversy that would result. There would be a real danger of stoking a fire of public resentment at perceived protectionism by the financial establishment that could do serious long-term damage.

So does that mean hedge funds can no longer short companies they believe are overvalued by the market? If huge crowds of coordinated small private investors remain intent on sabotaging them whenever they do so, it just wouldn’t be viable.

But who then performs the ‘predator’ role in the stock market ecosystem? The WallStreetBets mission idealists will argue companies that are genuinely no longer viable as stock market constituents will inevitably perish in any case.

But those who still have a chance to turn things around and come good again won’t be denied that chance by hedge fund short attacks. With their remaining assets of value then stripped by the same, or other, hedge funds. It’s not long ago that Tesla, currently the most valuable automaker in the world, was the most shorted company in the world.

Tesla survived when many others would not have. It’s perhaps no surprise Tesla CEO Elon Musk has been wholeheartedly cheering on the WallStreetBets crowd from the side-lines.

But it’s hard to argue Gamestop and Blackberry are good comparisons to Tesla. Both look like companies from a previous era unlikely to succeed in a new pivot and Apple-esque rebirth. WallStreetBets think its not short attacks by hedge funds, but time and ‘natural’ market forces, that should decide that. But will companies like Gamestop being left to limp on because predators are afraid to short them lead to a healthier, more equanimous financial market? That’s a bigger question.

It’s still far from clear what the final outcome of last week’s crowd-sourced hijacking of the financial establishment will be. This story has a long way yet to run.

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