It seems inevitable that the populist forces that have disrupted almost everything else in recent years would eventually arrive to democratize investing. But the sheer impact of retail trading has been shocking, primarily to financial professionals who appear ill-equipped to deal with it. Organizing via social media, the amateurs have been able to send so-called “meme stocks” likeGameStop Corp. soaring, while hedge funds that have been betting against the chosen companies are in pain. Some worry that the battle between the “flows” generated by small investors and the “pros,” or professionals, are artificially pumping stocks higher in a feedback loop that could lead to a collapse. Others worry the wild trading is ruining the purpose of capital markets entirely: the efficient allocation of capital.
1. How did this all start?
Online brokerageRobinhood Markets Inc. and other app-based platforms have brought a new wave of at-home traders into the market — many of them working from home or idled by the pandemic — raising concerns about the “gamification” of investing. Those onr/wallstreetbets — the Reddit forum dedicated to “making money and being amused while doing it” — have set their sights on exploiting a financial system that’s perceived to have locked them out for years. Much to the horror of the financial establishment, r/wallstreetbets then figured out a way to capitalize on this system and bend it to their own will.
2. How are they changing the way markets work?
Traditional value investing used to be about finding an undervalued company and buying the stock while it’s relatively cheap, in the hope that it would appreciate. To the retail traders, it’s not clear whether value matters very much. Some of the stocks targeted are seen as a long way from profitability and from the type of fundamentals that would normally attract investors. Yet once a stock gets going now and the price starts rising, it attracts even more attention and flows from the r/wallstreetbets crowd. One way of thinking about this is that prices used to be self-limiting. Stocks would rise to a point where valuations (earnings multiples or price-to-book) would become unattractive, which would cause the stock to go down and give valuations a chance to normalize. Nowadays, prices can go much higher than traditional security analysis might suggest.
3. Why is that?
Flows before Pros is one way to put it. The simple premise here is that in an environment where flows matter more than fundamentals, the guy trading stocks in his basement might be better equipped to judge where money is going next. He might have a better sense of the strength of a stock’s particular “story,” for instance, or a better sense of where the forum’s hive mind will go next, than portfolio managers wedded to their valuation models. In a more-than-a-little-ironic turn of events, the professionals may now be chasing retail flows.
4. Who are some of the pros here?
Short sellers — funds that borrow a stock and sell it, betting that the price will have gone down by the time they have to buy it to give it back — have become the target. Such firms usually would unveil a new position to great attention, expecting to cast a cloud over the company’s shares. The scrum this year over GameStop — in which retail traders have gonehead-to-head with short-selling firm Citron Research — suggests that could become a thing of the past. A hedge fund or short-seller advertising a bet against a stock might now be the equivalent of waving a red flag to r/wallstreetbets’ herd of bulls: a signal to charge in withcall options and force a move higher. The predators have turned prey.
5. What’s the strategy?
The folks on r/wallstreetbets often target stocks where they see a possibility of exploiting a structural weakness in markets. For instance, some have been upfront about buying stock options to try to squeeze share prices higher. (Options are contracts that give the holder the right to buy or sell the underlying security at a predetermined price after a set period of time, and the new and commission-free apps such as Robinhood have made options trading far easier.) The idea is that buying a ton of options forces market-makers — the middlemen in the transaction — to hedge their own exposure by buying the stock in the underlying company. That dynamic may be enough to move a target share price upwards, which can then spark more call-buying in a frenzied feedback loop: The stock goes up, short sellers give up, they buy stock to surrender, and their buying pushes the stock up more.
6. Can the small really outweigh the Wall Street whales?
The thing to look at here is not the amount of money that retail investors are spending, but the amount of leverage embedded in that spend. Here’s one scenario:
- Bob has a Robinhood account. He bought a single $3,250-strike weekly call option contract on Amazon stock on Aug. 14 for $1,500. That option happens thanks to a market-maker — call her Jenn — sitting at a large dealer-bank. But Jenn isn’t taking the other side of Bob’s trade, instead she is aiming to be a neutral facilitator. Her job is to make markets, not bet on them, so she wants to hedge her position. She does this by buying Amazon shares, making a calculation based on what’s calledthe delta of her position. The delta is how much the option will change in value based on the price of the underlying stock. In this case, she judges that she needs to buy $66,100 worth of Amazon stock to get to neutral. If shares of Amazon go up, she might have to pay out on Bob’s option, but at least that will be offset by the gain on her Amazon stock.
- A few days later Amazon stock does indeed rise, going up 5%, so Jenn needs to rebalance her books in order to keep her position neutral. This time, because the delta of her position has moved higher, she needs to buy even more stock. In fact, she needs to buy $230,000 worth of Amazon shares. Bob’s puny $1,500 outlay has been transformed into $230,000 worth of share-buying.
- By targeting dealers’ exposure in a concerted way, some retail traders are in effect trying to take advantage of a phenomenon known as a “gamma squeeze” — betting that as the value of Amazon stock gets closer to an option’s strike price, dealers will have to buy more and more of the underlying stock.
7. What about the hedge funds’ shorts?
Gamma squeezes can be more effective when coupled with a “short squeeze” in a company’s shares. Traders on r/wallstreetbets have often identified companies with a lot of short interest and a limited number of shares available for trading. That makes things harder when short sellers have to scramble to buy back shares and close their positions. This kind of dynamic also helps push the price of a stock up, feeding the loop. The hedge fund Melvin Capital revealed Jan. 25 it had accepted an injection of$2.75 billion from rivals Citadel and Point72 Asset Management after short positions left it with losses of 30% for the year.
8. Is this just a game?
It would be tempting to dismiss all of the above as a game if it weren’t actually moving stocks and impacting real companies. Shares of GameStop, a software retailer, have surged exponentially this year — drawingattention even from Elon Musk, whose own soaring stock made him theworld’s richest person this year. Message boards have been alight with suggestions for what GameStop could actually do with that very real money (think strategic acquisitions and expansions to grow its market share). So at some point these random flows start impacting fundamentals too.AMC Entertainment Holdings, another meme stock,avoided bankruptcy in late January by capitalizing on a stock rally fueled largely by retail traders. Some hedge funds may be selling some of the stocks they’re mostbullish on to cover losses, which would hurt performance.
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reddit.com10:08 PM · Jan 26, 2021
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