Day Traders Collide With Wall Sreet
A rebellion led by day traders astounded equity markets last week as some of the most prestigious names on Wall Street endured multibillion dollar losses on their short positions. A swarm of amateur traders targeted small-cap equities heavily shorted by hedge funds, as a retaliating movement against the excessive influence of financial institutions on the wider financial system. Reminiscent of previous retail trading frenzies, those involved ‘weaponised’ options derivatives to their advantage by purchasing ‘Out-of-The-Money’ calls and the stocks themselves as means to drive price rallies. This en-masse coordinated effort was initiated on user-generated social media platforms Reddit and Discord. [1]
Short-Selling: When an investor borrows a security and sells it on the open market, planning to buy it back later at a lower price. Short sellers bet on, and profit from, a drop in a security’s price – which can be contrasted with long investors who bet on a price increase. [2]
Out-of-The-Money Calls: An OTM call option will have a strike price that is higher than the market price of the underlying asset. [3]
Sharp upward movements in share prices of such spurned and poorly performing companies marked the burgeoning influence of retail traders on markets, who have collectively managed to ‘short squeeze’ stocks such as GameStop, AMC Entertainment and BlackBerry, amongst others.
Retail traders describe their infuriation against Wall Street’s capacity to consistently come out on top in times of crises. They notably blame these institutions for the misery caused by the global economic fallout in 2008 and some evoke seeking personal revenge in this regard.
And so this anti-establishment battle is proving successful so far, as hedge funds such as Melvin Capital and Citron Research suffered large losses as GameStop stock surged 1500% on Wednesday 27th by market open. Melvin Capital was forced to seek a $2.5 billion cash injection from rivals Point72 Asset Management and Citadel after their large losses. Total short-selling mark-to-market losses by Friday 29th amounted to $3.3 billion. [4]
Gamestop Short Squeeze
GameStop is a typical high street video game retailer whose share price has been floundering for the last six years. The company’s negative prospects were exacerbated by an accelerated shift of the gaming industry online caused by the pandemic. This has led to many hedge funds and institutional investors betting on their eventual demise as an almost certain prospect. Thereby around 72 million GameStop shares were shorted before the current bull run, representing 140% of the total capital of the company. Other stocks heavily shorted include AMC Entertainment, Blackberry, Nokia, Bed Bath & Beyond, Beyond Meat and Evotec, against which Melvin Capital currently holds the largest short by percentage of shares shorted on a European company (6%). [5]
Abundant liquidity and low cost of leverage enabled these considerably risky short positions and meant that these investors were particularly vulnerable to price rallies, and especially a ‘short squeeze’. Retail traders saw an opportunity to collectively buy all of the aforementioned stocks, and enforce a squeeze. As share prices rose exponentially, all short hedge funds were forced to liquidate their positions and buy back the stock they initially borrowed for their shorts, fuelling the rally further. [6]
Why were call options so significant in GameStop’s rally?
The extensive use of ‘Out-of-The-Money’ call options were a catalyst towards the surge in share prices. Their particular dynamics entail that if a call strike price is attained, brokers are obliged to deliver the shares and require to hedge themselves too in the process, either by passing on the option contract to another counterparty or entering the market themselves, once again driving the rally further. As seen below, this surge in options activity with regards to GameStop specifically is seemingly unprecedented. The rise in activity has been particularly dominant in trades of smaller magnitude, often 10 call contracts or less, highlighting their strategic use by individual retail investors as opposed to financial institutions.
Coordinated activity to this extent via social media presents a new challenge for the Securities and Exchange Commission (SEC) and financial regulators who have sparked a probe into this unprecedented market frenzy, delving into whether market manipulation was involved. Never have retail investors ‘squeezed out’ institutional investors to this extent, yet most say the SEC will find it challenging to prove a case of manipulation. [7]
Online brokerages such as Robinhood, Interactive Brokers and others halted trading on Thursday the 28th, in what caused outrage across social media.
The Repercussions – Are We Witnessing a Social Movement?
We are witnessing a changing demographic of market investors dipping into fundamentally flawed companies as widening implications are going well beyond the long-short battle. Perhaps this ‘populist’ movement signals a social opportunity for day traders in addition to a lucrative one.
Such distorted financial conditions may be signalling a lasting power shift enabled by social media community platforms. Indeed, some believe the repercussions of large, coordinated short squeezes may affect the integrity of the equity market and hurt other parties such as pension funds.
No matter the outcome, these dynamics will be addressed by regulators as there are broader financial stability issues at stake.