This week, the stock market went bananas. A handful of obscure stocks rallied hundreds or thousands of percent in a few short days. This is my best attempt at explaining the mechanics of what is going on. There is no investment advice or predictions about what happens next.
Let’s start with the hedge funds.
Hedge funds offer a range of investment strategies, but one of the more common is called market neutral. A market neutral hedge fund will buy stocks that it hopes will go up, but it will also short stocks that it hopes will go down. By having some positions that it wants to go up and some that it wants to go down, it is not reliant on the direction of the overall market.
When it shorts a stock, it must borrow the stock from someone else and sell it. Its goal is then to buy it back at a lower price in the future and return it to whoever it borrowed from.
Now, the universe of investable stocks is not infinite. There may be 3,000 or so stocks that are big enough for hedge funds to really invest in. Given that the stock market has been doing rather well recently, there are not a lot of obvious names for the hedge funds to short.
The hedge funds have a lot of money to put to work, but a limited universe of stocks to choose from.
This is where GameStop comes in.
Many hedge funds look at a company like GameStop and see a bleak future. It’s a retail company that was a staple in malls 20 years ago. It doesn’t look like the wave of the future. The result is that many hedge funds decided to short this stock. It was shorted so frequently that more than 100 percent of the shares were borrowed from shareholders to short.
Enter the Reddit message boards and COVID day traders. The people on some of these message boards have been plotting and coordinating trading strategies for the last 10 months, and they seem to be getting more successful, in addition to getting more attention.
A couple of weeks ago, they started talking about buying GameStop. Traders on these forums started to buy the stock itself, as well as options to buy the stock in the future. Their goal was to trigger a “short squeeze,” where they force the hedge funds to bail out of their positions.
If enough people buy the stock and options, it pushes the price up. That’s simple supply and demand.
However, as the price starts to rise, the hedge funds that owe the stock to someone start to see potential losses pile up. They must buy this stock back to return it to whoever they borrowed it from. The more the price rises, the more compelled they are to buy it and close out their short positions.
As the price rises further, the hedge funds that shorted the stock eventually give in and buy the stock. Buying the stock back only pushes the stock price higher. This short squeeze creates a feedback loop that drives the price higher and higher. The price of GameStop went from less than $20 per share to almost $500 per share at its peak.
Keep in mind that GameStop itself is not doing anything meaningful to trigger this rise in prices.
Retail investors and day traders are calling it a revolution of financial markets. They are out to destroy the hedge funds that they see as soaking main street investors for decades. This is a coordinated attack on the hedge funds. The media attention may only exacerbate the situation.
By Thursday morning, the favorite trading platform of the day traders, Robinhood, had restricted buying of the most heavily traded names, including GameStop. This only angered the members of the Reddit thread who are coordinating the attack. It’s now an all-out war between the day traders and the hedge funds.
How it all ends is anyone’s guess, but it’s a fascinating and potentially revolutionary moment for the financial industry.