How Redditors Beat Hedge Funds at Their Own Game(Stop) (2024)

Game on. Photo: Michael M. Santiago/Getty Images

GameStop is a publicly traded company, best known for selling video-game discs and cartridges in shopping malls.

This is a poor niche for a profit-seeking entity in 2021. It has never been easier to download some new lark onto your gaming console from the comfort of home. And it has never been less wise to make an unnecessary visit to a shopping mall.

Until recently, the price of GameStop shares reflected these realities. Whereas in 2007, one had to pony up $62.11 for a piece of GME (its ticker name), that figure had fallen to $18.84 by New Year’s Eve 2020. And although the firm had made a big fuss about how it was pivoting to ecommerce and would soon rise like a phoenix from the ashes (and/or shuttered strip mall), conventional wisdom on Wall Street held that its stock had nowhere to go but down.

But the value of a company can’t be reduced to its expected future earnings. One must also consider a wide range of other factors. Among them: How much nostalgia does the firm inspire in users of the Reddit forum r/wallstreetbets? And would a rally in GameStop shares be funny? Which is to say, has the firm crossed the “so bad it’s good” threshold, as inadvertent comedic masterpieces like The Room or Troll 2 had done before it?

America’s top hedge funds failed to ask these questions. Fortunately, the collective wisdom of rational market participants ensured that they were eventually incorporated into GME’s stock price. And, as of 3 p.m. Wednesday afternoon, a share in the GameStop corporation attained its true, objective value of $321.14.

All right. Enough snark. You didn’t come here for mirth. You came for an explanation of how the stock market works again, because now that a stake in GameStop is worth more than one in Goldman Sachs — and a herd of Redditors have wrecked major hedge funds, while threatening to trigger a full-blown market correction in the process — you’re no longer sure you get this “late capitalism” thing.

How to get rich or lol trying.

Say you’re a hedge fund that has determined, through expert analysis, that the future of video-game retail is even bleaker than its present. One way to make money off that insight would be to borrow shares of GameStop, sell them for cash, wait for the price of such shares to inevitably fall, then buy them back at a lower rate and return the repurchased shares to your lender. This is called “shorting a stock.” And it can be a risky maneuver. To borrow shares, you need to put up collateral, and be prepared to return such shares whenever your lender asks to have them back. If the shares you borrowed start climbing in value, then you’ll have to find more collateral to satiate your lender while waiting for the market to finally recognize the truth of your analysis. If you run out of collateral, or your lender runs out of patience, you’ll need to buy back those shares at a loss.

And when you do so, you’ll make life a bit harder for all of the other traders who made the same bet that you did. This is especially true if you are a multibillion-dollar hedge fund that has amassed a large short position in a given stock: After all, the moment you buy back a large number of shares in a given company, you increase market demand for such shares, and thus put upward pressure on their price. That can push the share price past some other hedge fund’s threshold for cutting bait, leading to still more market demand for the once-derided shares, which proceed to surge in value. This is called a “short squeeze.”

Now, say you are a bored Reddit user with a fondness for gambling, resentment of Wall Street, and a small amount of spare capital. One way to amuse yourself — and potentially make money — would be to (1) gather with thousands of other similarly inclined people in an internet forum, (2) identify stocks that are being heavily shorted, and then (3) collectively buy up a bunch of shares in those stocks, so as to orchestrate a short squeeze.

Better yet: To get more bang for your investment buck, you could buy call options for your desired stock. A call option is a contract that entitles its owner to buy a given stock at a specified price within a specified time period. And it’s a great financial product for investors whose appetite for risk outstrips their cash on hand. To see why this is, consider the following from Matt Levine:

[L]ast Tuesday (Jan. 19), you could have bought a $50-strike call option on 100 shares of GameStop stock expiring this coming Friday (Jan. 29). Bloomberg tells me this option would have cost you about $3.35 per share, or about $335 for a 100-share option contract; the stock closed that day at $39.36. If you sold the options on Friday (Jan. 22), when the stock closed at $65.01, they were worth $18.16 per share. You put in $335 and got back $1,816; you made a 442% return in four days. If you had just bought 100 shares of stock instead, you would have had to put in $3,936 to get back $6,501, a 65% return.

Now, say you’re a market-maker who is fielding a ton of bullish GameStop call options. Your goal is not to take the other side of these bets — you just want to neutrally facilitate everyone’s trades. Thus, to hedge against the risk that GameStop shares will rise to the bizarrely high “strike” prices people keep asking for, you need to buy up a certain number of GameStop shares yourself. If, in the ensuing days, a short squeeze is triggered — and the value of GameStop shares rises beyond all-expectation — you will need to buy more of your own shares to keep your books neutral. In doing so, you will put upward pressure on the price of the stock, which could force more shorts to buy, thereby increasing the price of the stock, leading you to buy more shares to keep your books neutral, in a cycle that’s vicious for hedge-fund shorts — and glorious for Reddit longs.

This mechanical process is what made it possible for a crowd of small-dollar retail investors on social media to propel price movements large enough to exhaust the risk appetite (and/or collateral) of a multibillion dollar hedge fund. As Bloomberg reports:

The first sign of trouble for hedge fund wunderkind Gabe Plotkin came in late October: A poster on Reddit’s popular wallstreetbets forum was taking aim at his wildly successful investment firm.

“GME Squeeze and the demise of Melvin Capital,” wrote the user, Stonksflyingup, referring to stock ticker of GameStop Corp. and Plotkin’s $12.5 billion firm. Before long, veryforestgreen weighed in: “Melvin Capital New Short Attack.” Then, greekgod1990: “Melvin vs WSB! And GME to the moon.”

… The attack on Plotkin’s six-year-old Melvin Capital shifted the balance of power in ways that would have seemed unimaginable only months ago. By Wednesday, the firm had capitulated to the amateurs and covered the GameStop short … So steep were the losses — about 30% through last week — that Melvin on Monday turned to billionaire hedge fund founders Ken Griffin and Steve Cohen — Plotkin’s former boss — to shore up the firm.

The GameStop mania will eventually run its course; there are many early investors sitting on massive gains, and their incentive to exit will eventually overwhelm their irrational exuberance, thereby triggering a sell-off.

But investor interest has already migrated to other heavily shorted stocks with strong nostalgia value: Shares in Tootsie Roll Industries soared 53 percent Wednesday morning, while a stake in AMC Entertainment Holdings has quintupled in value over the past week.

Is this time different?

Manias have been around for as long as financial markets have. And retail investors have been hyping stocks in chat rooms — then making their collective presence felt in markets — since the dot-com boom.

But three ingredients of the present madness are novel: (1) Fee-less online trading platforms that enable retail traders to buy and sell call options with a few flicks of their thumbs, (2) social-media algorithms that identify highly engaging financial-market stories, and then direct users to those stories, and (3) a world-historic pandemic that briefly made sports betting impossible last spring, causing a large population of gambling addicts to develop day-trading habits.

The pandemic won’t be with us forever. But absent new regulations, those first two factors will be durable sources of volatility that investors will need to account for when structuring their portfolios.

As Dave Nadig of ETF Trends writes:

[S]ocial media — which includes the curation algorithms of TikTok, Reddit, Robinhood, Amazon, Netflix, etc. — is designed not to do anything good for you (the consumer) but to keep you engaged on the platform you happened to launch from your phone.Nearly by definition, this leads you down a funnel into which it is very difficult to return. Once your TikTok feed is full of stock tips, it’s nearly impossible to get rid of them.Once you start following /r/WallStreetBets, you’re going to get the most sensational, clickbait posts bubbled to the top of your window: Go deep, Go narrow, Stay engaged.And do it in a market designed to take those few seconds of attention and execute on them.

… That’s what’s new here. It’s not that this generation of daytraders has invented daytrading or learned how to use options for the first time or even swarmed a “story stock” (now we call them “meme stocks” I guess).What’s new is that an entire generation of investors is locked at home with little to do and a set of services on their phone designed to funnel them into the most extreme, most dopamine-driving financial ideas.

And once those investors are herding around a given “meme stock,” bloggers will start drafting explainers on the subject to net their employers’ a share of the topic’s search and social traffic, marginally increasing the hype around that stock in the process.

Is this the French Revolution of finance?

Former White House press secretary Anthony Scaramucci thinks so. And there is certainly a populist verve to Redditors getting rich at the expense of large investors, while making a mockery of the notion that private financial markets rationally allocate capital. What’s more, at least some of the GameStop longs appear to have political motivations (of a sort).

This said, it is far from clear how progressive the ultimate redistribution of wealth from the GameStop craze will be. Eventually, this stock will come crashing down to Earth, and when it does, it will make many ordinary people who got caught up in the mania significantly poorer. When psychologically fragile people suddenly lose large sums of money — or what they believe to be large sums of money — they sometimes kill themselves. And nine months into the COVID pandemic, there are quite a lot of psychologically vulnerable people spending too much time on Reddit.

Another less-than-populist aspect of this drama is that the hedge fund that’s been hardest hit — Melvin Capital — did not become the favored target of WallStreetBets on account of its unique avarice or unscrupulousness, but rather, its exceptional transparency:

Why they singled out Melvin remains a mystery. As far as hedge fund managers go, Plotkin is considered low key. He doesn’t show up at many conferences or hobnob at society balls. Former colleagues and current investors say he’s a nice, quiet guy — not the type to make enemies.

The most obvious explanation is that his positions were in some sense knowable. Hedge funds generally go to great lengths to guard their short positions. If they use put options, for example, they buy them over the counter, which means they don’t have to list them in regulatory filings. Plotkin’s filing in the third quarter showed put options on 17 companies, many of them highly shorted names.

Thus, for Wall Street, the upshot of all this is going to be: Never let regulators or the public know what your short positions are. Which doesn’t seem like a huge win for “the 99 percent.”

Finally, GameStop mania is putting downward pressure on the entire stock market right now: As hedge funds see their shorts backfire en masse, they’ve started selling off shares of companies with strong fundamentals, just to cover their losses, a move that drags down the value of the market as a whole, and with it, many ordinary Americans’ 401(k)s and trade unions’ pension funds.

To this point, the S&P’s downward dip has been tiny. And on the list of America’s problems, “equity values aren’t high enough” ranks low. So, the GameStop rally isn’t an especially lamentable phenomenon. But it isn’t the storming of the Bastille either. We aren’t witnessing a popular uprising against the tyranny of finance capital. We’re just trying to mine a little more dopamine from pixels while the Earth slowly dies.

Tags:

• wall street
• finance
• business
• the economy
• gamestop
• stonks
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