Ride it to the moon. Hysterical speculative investor behavior. Insane Volatility. Explosive price increases. Short Squeeze. Gamma Squeeze. – That is all in a couple of weeks. Do you still want to ride this rollercoaster?
The last couple of weeks’ actions have been a standoff between the Reddit investor group WallStreetBets and hedge fund short sellers, which have reached the upper echelons of ‘the establishment’ with the Federal Reserve and Biden administration closely watching the frenzy. Many firms restricted trading in individual stocks this week, further adding fuel to the already prevalent sentiment that small investors always lose.
So, what happened?
The war between Wall Street and Reddit
Let us start with defining short selling:
Short selling is a bet against a company where the investor thinks the company’s price will decline. If an investor wants to sell stock ABC and does not own that stock, they will need to borrow it from a brokerage company and sell it immediately at its current price. They borrow the stock and sell it immediately at $10 and repurchase it at $6, returning the borrowed stock to the brokerage company and making a $4 profit—an attractive trade.
What happens when the stock goes up? If stock ABC goes to $16, the borrowed stock will still need to be returned to the brokerage firm, but now it is more expensive to buyback. Their loss is $6, the $16 cost to buy back the stock minus the $10 they received when they sold the stock. Now it looks like they made a bad bet. Risky positions like this can have an unlimited loss as there is no limit to how high the stock price can go.
What happened with GameStop?
Along came the Reddit community WallStreetBets and crowdsourced an idea.
The Reddit community recognized that a hedge fund had a large short position on GameStop and they would be able to make money if the price increased. Retail traders from the forum convinced the group to buy the stock directly or with options, thereby taking the opposite side of the trade to the hedge fund, who betted that the video game retailer would fail.
When these multibillion-dollar hedge funds do this at scale, and the price goes against them, they start to lose money quickly. When short sellers get uncomfortable, they need to have more collateral or buy back the shares they sold. They repurchased the shares themselves and pushed the price up even further, and this self-perpetuating action is a short squeeze. Short sellers were also raising money in other parts of the market to cover their losses and get their portfolios back to balance, which led to increased volatility.
Three ways to not lose the game:
1. Understand your investment
If you could ask anyone from the Reddit forum the reasoning behind their purchases, it may follow along the lines of:
Takedown Wall Street
Many Reddit posts expressed their anger at the increasing wealth gap and income inequality in society. These ideas landed in the palms of the six million+ forum readers at home, and they felt empowered to do something. It brings to light the old-world divisions in the investing world: Retail vs. Institutional. Smart money vs. dumb money. The boundary-less internet world we operate in shows the breakdown of these conventional viewpoints, where retail investors could make a change and move the market.
In it to make a quick buck
GameStop had a 450% return in just five days (as of writing this). It can be hard not to press the buy button when investors see these kinds of returns.
Do they love videogames?
A combination of all these feelings culminates in a collective sentiment that has nothing to do with GameStop’s fundamentals.
2. Beware of herd mentality.
“Everybody is buying GameStop; I need to get in on this.”
The herd can be powerful but also dangerous. Ten antelopes could probably take on a single lion unless that lion led them into its den as a trap. It is easy to be persuaded by the crowd, especially when that crowd is making money. For an investor to imitate others, they must be aware of and influenced by their actions. It is alarming that this was possible within a community that has never met. Making a decision based in part on the behavior of others does not consider your situation. Is this investment right for you? Can you personally weather the volatility in this stock?
3. Bubbles eventually burst.
This game is going to get ugly when the bubble bursts. The people who entered the trades last, at already high prices, will significantly be affected as the price of GameStop collapses back to its intrinsic value. It is likely to happen as there is such a large disparity between its price and valuation. When this happens, the fall may be epic.
Even if you have found the next GameStop, the ride may be painful. GameStop and other stocks with high short interest are risky. They are being driven by market sentiment, not by fundamentals or quantitative metrics. That is why Adviso Wealth takes a long-term approach. One of the silent advantages of being a long-term investor is that you do not have to waste energy on short-term speculative investments.
Adviso Wealth can help you think clearly so you do not succumb to your biases or what others say and do. We can visualize the situation from a different perspective, so you do not have to.
Adviso Wealth is dedicated to working with people just like you. We want to give you the clarity and confidence you need to achieve your personal and financial goals.
To learn more, visit advisowealth.com or email email@example.com