Business
How Reddit Trolls Cost Hedge Funds $6 Billion
The GameStop Stock Saga has some hedge funds licking their wounds while smaller independent traders reap the benefits.
When it comes to financing, there is no accounting for the power of Reddit. Some hedge funds learned this the hard way last month when a group of retail traders organized on the subreddit, WallStreetBets bet against a short sell of the company GameStop. Now that the dust has settled, let’s breakdown what happened in this epic showdown between Wallstreet and internet trolls.
It All Starts with GameStop
GameStop is a video game retail store with over 5,000 stores across the United States. They specialize is selling new and used video games and equipment along with some novelty toys and merchandise. It seemed that GameStop was on the downward trend over the last year. With less people shopping in malls, Xbox and Playstation introducing digital only consoles, and COVID-19 lockdowns, GameStop business was on the decline.
In September of last year, investor Ryan Cohen bought a 13% stake in the company and pushed them to move their business to an online model. That’s where the hedge funds came in. Eagle-eyed investors saw this as a sure-to-fail gambit and moved to short the stock.
What is ‘Shorting a Stock’?
Contrary to traditional investing, shorting a stock is how traders look to make money off a stock’s failures rather than success. An investor will borrow the stock of a company from someone when they anticipate a price drop. They sell it and repurchase it once the price goes down and keep the profit minus some interest.
In other words . . .
Suppose Kevin has 100 oranges and the going rate for oranges is $2 apiece. Kevin’s friend Max borrows 10 oranges from Kevin and turns around to sell them all right away for $2 an orange, totaling $20. After a couple of days, the price for oranges drops to $1, so Max goes out and buys 10 oranges for $10. He then returns the oranges to Kevin, making a cool $10 profit in the process.
This is short selling in a nutshell.
Short selling is something that happens all the time on the stock market. It is perfectly legal and, in fact helps regulate the prices of particular stocks. There is a catch, however.
In the case of the oranges – what happens when Max sells the oranges he borrowed from Kevin, and instead of the price dropping later, the price goes up? Now, Max has to spend $3 on an orange. To return the oranges to Kevin, Max has to spend more money than he made and lose $10 for his efforts.
The Showdown
When some big hedge funds eyed the downward trend of GameStop, they decided to short the stock. They borrowed many shares from the company’s shareholders and sold them immediately in anticipation of the price drop.
Enter Reddit
A subreddit group, wallstreetbets caught on to the GameStop short and decided to band together and apply a ‘short squeeze.’ They used their clout to urge amateur investors across the internet to purchase stock in GameStop, declaring a fight against the big Wall Street firms.
When the subreddit and their legions bought up all the GameStop stock, the price shot through the roof. On January 12th, GameStop was trading at $19.95/ share. In two days, it nearly doubled. By January 25th, the stock had jumped to $76.79, and on the 27th, it was trading higher than TESLA at $347.51.
Forced to buy back at over a 1,500% increase, the short-selling hedge funds lost big time. Melvin Capital Management lost 30% of the $12.5 billion it was managing. The Guardian estimates, the Redditors cost hedge funds upwards of $6.12 billion.
On the flip side, many of the Redditors and amateur traders stood to make an exorbitant profit if they sold at the right time. Some traders claimed to have made $11 million in the whole ordeal by buying low and selling high.
Behind The Madness
Wallstreetbets claims the short squeeze was implemented as a way to stick it to the big hedge funds. It was seen to be class warfare, with many angry with the big-time traders making money by manipulating the market in a way that the little guy couldn’t.
It wasn’t just the internet trolls. Elon Musk got in on the action, driving up the GameStop stock with a single tweet.
The Aftermath
Trading had sky-rocketed in an unprecedented way. Robinhood caught heat for temporarily suspending the trading of GameStop. They claimed it was because they did not have the capital to back the trades. Notifications on the app warned traders of the dangers of short-selling.
Some criticized the app for cutting out the little guy during a historical time to make money.
GameStop has since returned to more modest trading but still trading significantly higher than it was at the beginning of the year. Robinhood has reopened trading to GameStop and issued a statement explaining their actions.
No doubt, big time hedge funds are weary to tick off the wrong people with their next short.