This week, the global stock market sank into Reddit’s hole.
A growing army of day traders has been a hallmark of the equity rally since the liquidation last March, as a mix of lockdowns, low interest rates and canceled sports competitions prompted more investors. daily to try their hand at the stock market. . This has accelerated since early 2021, as the Reddit bulletin board and its rapidly expanding r / WallStreetBets community have managed to funnel energy into a handful of previously unloved stocks.
The result was an eventful week for these actions at the center of the action, which extended to individual actions around the world. Frantic trading periods have triggered market restrictions and brokerage restrictions on what clients can buy.
Global stock market volatility has increased, and people far beyond the financial industry have been transfixed by the battle between Wall Street and the destitute individual investor.
How did we get here?
Reddit traders take on short sellers
For months, some Reddit users – led by one called DeepFuckingValue – have pleaded for an investment in GameStop, a video game retailer attempt a turnaround in the face of stiff competition online. The appointment of Chewy’s founder Ryan Cohen to the board gave the bulls their first big push in early January. But the investment case they presented was boosted by a major technical issue: the possibility of profiting by pushing against Capital Melvin and other hedge funds that had bet heavily on the decline in the GameStop share price.
These hedge funds make money by short-selling a company’s shares – in effect betting that the stock price will go down. The investment firm borrows the shares of the company and sells them, with the hope of buying them back at a reduced price and returning them, while pocketing the difference.
At one point, over 100% of GameStop’s stock was on loan – a seeming oddity due to the fact that a stock can be borrowed, sold, and re-loaned multiple times.
Day traders realized that if they could actually push the retailer’s shares higher, it would leave its short sellers facing big losses, forcing them to buy back the shares to “cover” their shorts, but worsen the losses to other shorts and setting off a higher spiral for the stock. This so called “short squeeze” proved to be a success, with Melvin and another short seller, Citron Research, closing their positions at a significant loss.
Other well-known short sellers, such as Muddy Waters, have acted quickly to reduce negative bets on other companies.
How options trading fueled volatility
Dramatic movements in the stock market – in GameStop and elsewhere – have also been fueled by day traders’ penchant for options, which offer the buyer the right to buy (call options) or sell (put options) a stock at an agreed “strike price” within a certain period of time.
When an investor buys a call – in effect betting that the price of the underlying stock will rise – the bank or other company that sells the option is about to deliver the stock to the investor at the price of. agreed exercise if achieved.
To protect itself, the broker will continually buy the shares as they approach the strike price, which encourages the price of the underlying stock to rise further. Some analysts claim that the day-trading crowd has learned to ‘militarize’ these dynamics, knowing that if they stage an organized buying frenzy, pushing stock prices towards the strike price, the so-called trading activity. cover will fuel the rally. This is sometimes referred to as “gamma compression”. The effect can be magnified with some companies that have a large proportion of shares loaned to short sellers.
The “ short press ” grows
The GameStop episode quickly spread beyond the retailer, to other stocks that are under the attention of short sellers, such as movie operator AMC Entertainment and former owner of Financial Times Pearson.
It has become a global phenomenon: On Friday, owners of rubber gloves listed in Malaysia skyrockets after being highlighted by users in the r / BursaBets subdirectory. And it’s not limited to stocks: The price of silver has risen in recent days after calls from Reddit users to jack up the price of a silver-backed exchange-traded fund and associated stocks.
The Reddit crowd didn’t do it all in their own way. Thursday’s trading was characterized by multiple trading stops and very volatile price movements for the most wanted stocks. GameStop fell more than 40% on the day and AMC fell more than 50%, after brokers decided to restrict new purchases.
What happens next?
Many commentators have warned that individual investors who pile into these hot stocks risk big losses when the euphoria wears off – or when companies take advantage of the rise in their previously moderate stock prices to raise new equity. , diluting the existing shareholders.
AMC’s rally allowed its Silver Lake creditor to do what one investor called the “trade of a lifetime»By swapping risky debt for stocks, after the stock price has exceeded a trigger price embedded in convertible bonds held by the investment firm.
But the Reddit effect doesn’t seem to go away quickly. GameStop and AMC made strong progress again on Friday in pre-negotiation. Hedge funds crave scratch message boards to see what action is next to grab the attention of the day-trading community. And r / WallStreetBets membership continues to grow.
In the process, the business model of commission-free brokers is tested, and short sellers – who play an important role in uncovering prices and uncovering corporate frauds – claim to be more “savvy” in businesses than they are. they target.
The big question now is whether regulators will act to contain speculation.