There’s a good chance you’ve heard of the website Reddit.
It’s an online forum where users can join communities based on their interests, like sports, video gaming, gardening… or even investing.
And one of these investing communities on Reddit has blown up in a big way:
Named “WallStreetBets”, this Reddit community is not a source of sage financial wisdom.
It’s notorious for its “YOLO bets”, such as buying out-of-the-money call options days before expiry in the hopes of hitting it big.
WallStreetBets was once the haunt of investment industry professionals looking for a place to relax and joke with like-minded people.
For a time, even personas like the currently imprisoned former hedge fund manager Martin Shkreli would visit to shoot the breeze.
In recent years however, and especially since the COVID pandemic, the forum has taken on a new life of its own as novice investors chasing the thrill of quick gains during the downturn piled on.
Now the fastest-growing community on Reddit, these new investors have taken some of the “meme” advice offered by WallStreetBets and acted on it.
- The most famous example, and one that’s gained massive traction this week, is GameStop (GME).
Look at this YTD chart…
What caused this insane runup in GME’s share price and trading volume?
Was it some explosive news release or company results? Did they get a buyout offer?
The answer is much more absurd than you’d think.
The Birth of the Meme that Killed a Hedge Fund
The beginnings of GME’s massive run begin over a year ago in September 2019, when a reddit user named DeepF*******Value decided to post their “YOLO” options play on GME to the community:
With starting capital of just US$53,566.04, DeepF*******Value decided to take a long position on GME by purchasing call options. At this time, GME stock was worth just about US$4.50.
DeepF*******Value cited their reasons for making the trade as including
“…[t]he fact that it’s worth quite a bit more than $8/sh and there are numerous catalysts that could trigger a reversion to fair value over the next 18mo.”
Reactions from the community were mixed.
After all, GME was a brick-and-mortar retail video game storefront (remember those?). Its performance was sagging in the face of increasing competition from digital video game sales.
With most of their sales growth coming from their collectibles segment as opposed to their core video game business, some were convinced that GME would soon be going the way of the dinosaurs, much as how video rental stores did before.
Over the next year, however, DeepF*******Value would staunchly continue to remain long. Even as the company traded sideways and continued to post monthly updates to the WallStreetBets subreddit.
- The company slowly trended back up and around the anniversary of their first post, DeepF*******Value would report back with nearly a million dollars in gains:
Even at this point, reactions were still mixed, with many applauding DeepF*******Value commitment but also many telling them to cash out their position.
Naked Shorts and The Evolution of Occupy Wall Street…
Others wondered just how such gains could be realized from a “meme” stock.
Had DeepF*******Value closed their position out at this point, this would’ve ended as just another footnote in WallStreetBet’s history of YOLO options trades.
But instead and much like the Bitcoin die hards, they continued to hold.
And share prices continued to slowly trend upwards.
There was a brief hiccup early last December when shares dropped almost 20% following a bad quarterly performance, but share prices steadily creeped up until hitting $20 on January 11th.
On that day, GameStop appointed the founder of online pet supply retailer Chewy.com, Ryan Cohen, plus two other e-commerce veterans to its board to focus on growing its own digital sales segment.
This was considered to be a good sign for the stock, as it was trying to evolve its business model in an effort to stay competitive.
- At this point, DeepF*******Value turned their $53k worth of GME call options into $3.2 million.
And WallStreetBets, now having nearly 2 million subscribers, and also having seen over a year of monthly – and sometimes weekly – updates from this user, was now very familiar with GME:
However, even despite this continual growth in GME’s share price, short interest – in essence, the amount of people who were short selling the stock because they thought it would go down – stayed strong on the stock.
In fact, there were more short sold shares of GME than there were actual shares of GME. This was caused by a phenomenon known as “naked short selling”, where shares that don’t actually exist are sold on the market.
Usually when short selling, the shares must first be borrowed from someone who owns the stock. When naked short selling happens, firms are selling shares without first ensuring there’s stock they can borrow to cover their short positions.
While naked short selling is illegal in practice, thanks to loopholes in the rules and poor regulatory oversight, naked short selling still happens in the industry.
Here’s where history gets made…
- GME had the highest short interest of any stock in North America, which some of the savvier members of WallStreetBets were quick to point out.
Some began speculating that a “short squeeze” would happen. This is where a rapid price runup would occur due to short sellers trying to cover their short positions.
Members of WallStreetBets pounced.
And the rest is history.
GameStop to the Moon
Just two days after GME’s positive news on the 11th, GME shares began climbing rapidly, first to $30, then to $40, then to $65.
But it wouldn’t be until early this week when the floodgates burst open, and prices were rapidly driven up by the combination of WallStreetBets hype-fueled buying and funds scrambling to cover their short positions.
- GME shares went from $18 to as high as $470 – a remarkable return in just four short weeks.
What about the short sellers, you ask? The hedge funds who thought that GameStop stock was going to drop instead?
Well, on Wednesday the 27th, two of the major short sellers of GME, Melvin Capital and Citron Research, were forced to cover their short positions at massive losses.
On the other hand, numerous posts on WallStreetBets abounded telling of novice investors who were able to pay off medical bills, accelerate their savings accounts, or pay down mortgages thanks to their GME positions.
In the midst of all this, hedge fund Melvin Capital desperately sought a cash infusion to help cover the losses from their now-underwater short positions.
So, in came fellow hedge funds Citadel LLC and Point72 Asset Management, who pledged $2 billion and $750 million, respectively, in exchange for non-controlling revenue shares in the firm.
But wait… Citadel? Why does that name sound familiar?
Wait a minute…
The Dark Side of the Moon
So far, the sentiment in WallStreetBets has been “the little guys sticking it to Wall Street”.
Certainly, the general vibe seems to feel as if retail investors have “won” a victory over the big hedge funds who have turned the markets into cash cows to milk at their own convenience.
However, there’s another side to the story here…
If you recall from our previous article on Robinhood, the favored discount trading platform of WallStreetBets and novice investors everywhere, Robinhood doesn’t actually handle their own order flow.
Instead, Robinhood sends their orders to a number of market maker firms who execute the trades on their behalf.
- And the lead recipient of Robinhood’s order flow, who gets over half of all of Robinhood’s trades, is Citadel Securities… part of the Citadel LLC group of companies, the same one that just “bailed out” Melvin Capital in exchange for a revenue share.
For a quick refresher, this order flow from Robinhood allows Citadel to “front-run” client orders by placing their own trades ahead of Robinhood users.
And it also allows them to take the other side of the trade when it’s profitable for them.
In other words, Citadel was handed information that WallStreetBets readers were looking to profit from a short squeeze on GME on a silver platter. And they didn’t know that just because it had become a hot topic on Reddit – they knew it because they could actually see the order flow and dollar volume going their way.
From there, it wouldn’t take much to connect the dots and see who would stand to lose the most from those orders: hedge funds with significant short positions like Melvin Capital.
Melvin Capital is not some sort of mismanaged failure of a fund. Since its inception in late 2014, Melvin Capital has been one of Wall Street’s best-performing firms.
It’s grown from $1 billion in Assets Under Management from the start to over $20 billion prior to the GME run-up. And delivered over 50% returns to clients last year even after fees.
So, when you think about Citadel being able to swoop in and purchase a revenue share of a historically strong-performing fund like Melvin Capital for bargain bin prices… you have to wonder…
How early were they able to see the writing on the wall? Did they even accelerate the process themselves?
Even when Wall Street loses, Wall Street still manages to win.
The Rise of Retail Investors
Of course, I’m not trying to make light of what retail investors, and WallStreetBets, have managed to accomplish.
Though Wall Street still stands to profit the most from the whole debacle, countless retail investors have walked away with gains as well.
And even just one month ago, the idea of retail investors being able to “take down” Wall Street hedge funds would have been unthinkable.
Melvin Capital and Citron Research will survive, of course – rumors of them having to declare bankruptcy are greatly exaggerated. Melvin still plans on taking in another $1 billion in new money next month.
And as Citron managing partner Andrew Left said on Wednesday
“We’ll become more judicious when it comes to shorting stocks. Doesn’t mean the industry is dead, but it just means you have to be more specific.”
This wave of investment euphoria has begun to spill over to other targets like AMC and Blackberry.
There’s even been a call to action on the silver markets, to “squeeze the silver shorts” in order to trigger a new silver bull market:
I can’t deny that many people out there have made tremendous gains in GME – 685% returns in just four weeks is the stuff of legends.
But I also have to offer a word of caution for those of you who find yourselves getting caught up in the hype.
Even though fundamental valuation has gone out the window in this instance, I still have to say this: GameStop’s business is not worth $450, not by any metric.
With fundamental valuation gone by the wayside and even technical analysis breaking down, that means the forces driving GME’s meteoric rise are purely based on investor sentiment.
- GME is only worth as much as it is because the people buying it believe it’s worth that much.
That’s the core of how markets really work. People buy what they think is going up. And sell what they think is going down.
Lessons and the Next Phase
This saga will continue.
It’s the establishment vs the rebels.
But, no matter how things end up, there are two lessons to take away from all this:
- Retail investors are a serious force for change in the investment industry.
They’ve proven that they can move the market in big ways, even to the detriment of multi-billion-dollar hedge funds. WallStreetBets has managed to accomplish what I’ve been trying to do with my own publication, Katusa’s Resource Opportunities – put power into the hands of the retail investor.
And the Katusa Army has changed the landscape of how money is raised with some of the largest financings in the resource sector in the last 12 months.
- Do Your Own Due Diligence.
I can’t stress this enough.
Understand what you’re investing in, and why, before you commit your money. While GME was a win – the win of a lifetime for many – there are many would-be investors who’ve been burned on WallStreetBets in the past as well, especially when it comes to options.
Even DeepF*******Value, the person who kicked off GME’s rise to prominence, had an investment thesis when they first entered into their long position all those months ago.
I’ve personally taken on short sellers before and it’s a vicious war. And our group wasn’t nearly as big as it is today.
But it gets very messy. And the game is armed with regulation, naked shorts and all sorts of tools that funds and brokerages can use.
At the end of the day, educate yourself. And stay safe.