How Did the Short Squeezing Phenomenon Disrupt Wall Street Businesses Recently?
The story of David and Goliath is not the first one that we usually think about when it comes to Wall Street.
Remember Michael Burry who correctly predicted the subprime mortgage crisis way ahead of its time? This is what he was told in a meeting by a Goldman Sachs representative:
“This is Wall Street, Dr. Burry. If you offer us free money, we ARE going to take it…”
Yes, in most cases that is true. Institutions and smart money are the Goliaths who usually rule over the retail investors, or ordinary people like you and I, when it comes to the financial markets. This time, however, the tables had turned.
Last month, the world saw the power of an army of online retail traders in action. What they lacked in institutional power and big capital, they made up by using social media and electronic trading platforms. And, the sore mistake that hedge fund Goliaths committed was to ignore this army until it was too late and get blindsided with the unchecked eagerness to make more money.
But enough of these biblical references. Let’s take you through the events of last month which has thrown the Wall Street money-making machinery into a frenzy.
What Happened?
At the centre of this episode lies a company called GameStop (GME). GME is a U.S.-based chain of brick-and mortar video game stores which was a fledgling enterprise in the 1980s and ’90s but was struggling in the new millennium due to the evolution of gaming tech, competition from digital distribution services, and the COVID-era lockdowns. Debts mounted to as high as $450m in Q4 2020 and sales contracted by 40% in the previous two years.
In April 2020, GME shares were trading at $2-$4. Analysts had compared its fate to the likes of J.C. Penney and Blockbuster Video, popular businesses which struggled due to similar market and technological changes.
But this presented big traders (particularly, traders from a hedge fund called Melvin Capital Management) with an opportunity to short GME shares.
Quick Primer on Short-Selling
Short selling refers to the ‘darker’ trading strategy of selling high and buying low (in that order). In phase one, the short sellers sell high by borrowing stock from shareholders. In phase two, they buy low by purchasing shares at a lower price, returning them to the lenders, and pocketing the difference.
So, for this strategy to work, the shares MUST go down in price. That is the underlying bet placed by the short sellers. Hence, the most suitable targets for short sellers are companies whose financials are in imminent decline (like GME) and have minimal prospects of recovery. Sometimes, it is also companies which have flawed business models, or have recently faced downturns or reputational damage (for instance, through fraud in case of Enron). Sometimes, companies which are famously overvalued (like Tesla) are also good targets for short-selling. Several short-sellers have repeatedly alleged that Tesla is “egregiously overvalued” because the company makes more money by trading auto emission credits than by selling cars, putting its business fundamentals into question.
Following the same strategy of short-selling, Melvin Capital gathered a short position valued at almost $55m against GME. Andrew Left, a prominent short seller, predicted that GME’s stock will plunge to $20 from the existing $40 on January 21st 2020.
The Prophecy Disproved, In Theory
Enter WallStreetBets, a Reddit forum, whose members found out about Melvin’s massive short position against GME. The information became available as soon as Melvin listed its put options (or, short sales) publicly, which the company is legally required to do as per SEC guidelines. Turns out it was not just GME that Melvin was short-selling but also a number of other companies: iRobot, National Beverage, Bed, Bath and Beyond, etc.
Members of WallStreetBets and other users began a massive campaign to try and debunk these positions by pouring money into GME’s shares and pushing its price up. The online community which consists of thousands of members, was united in a single pursuit — to raise the share price of GME by buying more and more of its stock. As a result, since January 11th 2021, GME shares spiked more than 500%. As GME shares spiked, short-sellers’ positions began to get more leveraged, with losses mounting to the tune of $5bn. This gave birth to one of the biggest short squeezes in history.
What is a Short Squeeze?
Simply put, short squeezing occurs when the value of a stock or underlying asset suddenly increases. It is triggered by events like a renewed or positive growth forecast, ultimately forcing traders who sold it short to buy it back.
There are three things to note here.
One, the short sellers incur far greater losses. Why? Because, the sellers leverage their bets with borrowed money from shareholders or other lenders. So, if the short sellers don’t secure a substantial difference, including interest costs and profit margin, before their short positions have expired, they have to pay lenders out of their own pocket.
Two, the profits in short selling are capped at a certain level. But the potential losses are infinite. This is how it works: let’s say you short a stock at $10. This means your maximum profit can be $10, assuming the stock price dives to zero, which is the lowest possible value for a stock. But if the stock price keeps rising above $10, your losses keep piling up because you bet against the price rising. Your potential losses are unlimited because you don’t know how far the stock price may rise, and how far you have to bail the lenders out.
Three. If the share price keeps rising, the stock value pulls higher and higher, until it eventually surpasses the capacity of the shorts to remain short. Think of it as the proverbial boat with a leak at the bottom. Short sellers try to bail out their lenders by covering, or buying, the stock at a high price (much to their disappointment) and swallowing their losses. At the same time, all this additional buying activity ultimately pushes the stock even higher and gives birth to more short positions to cover until ALL the short sellers are swept out!
That is exactly what happened with GME and Melvin. Short sellers have reportedly gathered a market-to-market loss of more than $6bn year-to-date in the stock. On the other hand, the retail investors who propelled this market charge with a buying frenzy have gained big (some users earning returns as high as 1000% ).
Is That Good or Bad?
Clearly, it was very good for the retail investors and very bad for the short sellers. And as it would seem, very ugly for Melvin Capital.
Short selling, per se, isn’t illegal. It is, in fact, a great tool that can be used to correct market inefficiencies. They help keep check on the raging bullishness of companies who thrive on the untouched assurance of investor optimism. Short selling helps break this assured haven of corporations by sounding early alarms on potential mismanagement or frauds.
On the other hand, short-selling is also a classic example of stock manipulation. But it is legal since the users are protected by the First Amendment of the US Constitution that guarantees freedom of speech, such as on online social media forums like Reddit. This means the short-squeezing campaign of WallStreetBets was not an example of insider trading, conspiracy, or even mob effort. It was a legitimate investor effort built through common consensus.
It was, however, one of the biggest short selling upsets to have happened in recent years causing $6bn in losses to Melvin Capital, a company that was valued at only $1.2bn two weeks ago. A few thousands of Reddit campaigners on an online discussion forum managed to drive GME to the moon by trading through hundreds of thousands of retail Robinhood accounts. The power of the many finally triumphed on Wall Street.
Where Does It Go From Here?
As much rejoice as the citizen socialists of WallStreetBets may be taking in, a phenomenon like this is not expected to last much longer. Market reinforcements for Melvin Capital have already started to pour in. A coalition of billionaire investors has come together with an investment of $2.75bn to rescue Melvin Capital in exchange of non-controlling revenue shares.
It is, however, too soon and risky to predict the next course of market upsets in the future. For now, let’s just say that the people who make the most money on Wall Street are the ones who are “drunk on youth, fueled by greed, and higher than kites”.
Not sure which group falls more appropriately into this definition given the current situation — the short sellers or the retail investors from Reddit!
(Originally published January 28th 2021 in transfin.in)
