WallStreetBets Reddit crowd vs. hedge funds takes new twist as financial establishment doubles down on Gamestop shorts

by Jonathan Adams
WallStreet

The hedge funds whose short positions on previously unloved stocks including Gamestop, Blackberry and Nokia was last week attacked by millions of small investors from the subreddit community WallStreetBets are fighting back. Last week a highly coordinated crowd of retail investors worked together to squeeze shorters in stocks, traders betting on their price going down.

The Reddit crowd purposefully drove the price of shorted stocks higher by taking long positions in an effort to force hedge funds into cutting their losses. With the share price of Gamestop, the stock initial efforts centred around, surging by up to 1000% at certain points last week, many shorters were ‘squeezed’ into crystalising losses by closing their positions.

However, perhaps motivated by the fear that allowing the Reddit crowd victory will have deep-running consequences on the viability of shorting strategies from here on in, hedge fund managers have now committed to digging in. They are upping the stakes, throwing their financial might behind what has become a symbolic battle.

Hedge funds are now playing with extremely high stakes. Their betting their financial health on a game of chicken with the Reddit crowd. It will come off if the crowd run out of enough reinforcements to keep matching the hedge funds’ exposure to their short positions. But it’s an offensive that smacks of do-or-die. If enough small investors take up arms against the hedge funds, they are in trouble.

Despite hedge fund casualties last week, Melvin Capital had to be bailed out as a result of the losses it suffered being squeezed out of its short position on Gamestop and Citron Capital also admitted defeat and closed its position, many others are still holding position. The depth of their pockets are yet to be found out. Which could worry the crowd, many of whom are small retail investors who could be badly financially damaged by defeat.

In fact, analytics group S3 Partners believes the number of Gamestop shares out on loan to short-sellers dropped by only 8% last week. It looks like for all the hedge funds squeezed out of their short positions last week, richer reinforcements have arrived. They believe they have the financial firepower to hold out until the bubble bursts.

The biggest risk lies in the fact that the upside for short sellers is limited to 100%. Short selling works by investors who believe a share price will fall ‘borrow’ shares for a small fee. The short trade will finish in the money if the share price falls in the meanwhile because when the borrowed shares are returned to their original owners, the short-seller pockets the difference if they are worth less. But that difference is capped at half the original price.

Traders taking long positions can theoretically generate unlimited returns, which means their potential upside is much higher. That is a disadvantage for shorters and means the hedge funds’ counter-attack relies on them being able to sit on extending paper losses until the crowd laying siege to the short positions gives up and goes home at some point. According to S3 data, traders shorting Gamestop are currently down $19.75 billion this year, including an $8 billion loss on Friday.

Melvin Capital, one of the hedge funds to already lose out, started the year managing around $12.75 billion-worth of funds. Last week’s carnage has seen that total drop to around $8 billion, including a $2.75 billion bailout secured last week from fellow hedge funds Point72 and Citadel.

However, there are always winners and losers during periods of market turbulence. Some Wall Street investors have profited handsomely from the clash between the crowd and financial establishment.

Fidelity, the giant U.S. asset manager, is Gamestop’s biggest investor, owning 13.7% of the company. Blackrock, the world’s biggest asset manager, owns 11.3% and the Norwegian sovereign wealth fund also holds equity in the video games retailer now worth $600 million. Gamestop shareholders have seen big paper returns.

But actual investors in Gamestop are now stuck in a tricky position. Their profits are only currently on paper. If the hedge funds win the tussle, they’ll be wiped out and turn to heavy losses. But selling shares now to profit-take would play directly into the hedge funds’ hands.

This story has twists, potentially several, left in it.



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