Melvin Capital lost nearly $3 Billion this week from pulling out of a position in GameStop (GME). How is it that the internet and casual day traders were able to force a renowned hedge fund to suffer such an enormous loss? It all starts with the concept of a short squeeze……
Not unheard of, but never really used in this manner, a short squeeze occurs when a number of investors have shorted a stock (promise to sell at a later date assuming the future price will be less), and the stock responds by increasing in price because those who currently own it will not sell. The resulting spike in price either forces short sellers to drop their position and lose money or, if they have the capital, to hold on longer.
WallStreetBets (WSB), an investment forum that mostly discusses extremely high risk trades in the form of meme and through an internet culture, began to drive the up the price of GameStop by voraciously purchasing GME, quadrupling its price in a short amount of time. Hedge funds, seeing this and thinking inevitably the price would fall again, shorted GME with the intent to profit off the decline when WSB members began to sell. But they did not sell. They held. And held. And held. This drove the stock even higher and made those short positions even more precarious. Why? A short position is often covered by margin, an investment loan that is leveraged by the account and account owner, so the longer these short positions are held, the more money it costs.
WSB knows this and continues to hold, understanding that every day they sit tight it costs the hedge funds who bet against them millions, and drives the price of GME a little higher. They are profiting by using the hedge funds’ own practices against them. For example, Melvin Capital was forced to sell out of their short position of GameStop and lost $2.8 Billion.
It is common knowledge that market manipulation occurs, and that behind the scenes unscrupulous players engage in illicit activity that ends up being profitable. Short squeezing is not explicitly illegal; sometimes a stock’s price will spike as a lot of orders come in to short the stock. However, explicitly colluding to cause a stock to rise or fall is not a legal trading practice. It is called pumping. WSB used the tactics hedge funds have been using for decades, but since it is an online forum, this makes a very difficult road for the SEC to travel.
There is talk of regulation and crackdown on these practices and those of day traders and their forums. We will have to wait and see what the SEC and Congress come up with to curb meme-trading phenomena and how they resolve the Wall Street flaws this recent GME insanity has brought to light.
Reach Out To Us: Beware the belief that anyone with a “Robin Hood” account can meme a fortune into existence. Both aggressive maneuvers by Wall Street’s big players and the resulting restrictions from regulators can create a “scorched earth” scenario for amateur investors. GameStop’s stock plummeted 44% Thursday, after days of rapid growth spurred by groups of small investors who gather online. The company’s stock is still 200% higher than it was at the start of the week. Better to have a well laid plan for your portfolio, properly diversified, adjusted for risk tolerance, and avoid the risks of short-selling which is nothing more than gambling.
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TFG Financial Advisors, LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities, and past performance is not indicative of future results. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.