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Games were played using Gamestop in the stock market last week causing some serious volatility. The games were waged on both social media and monetary fronts in battle between Wall Street behemoths and small individual investors organized on Reddit r/WallStreetBets (WSB). It even mirrored the big tech versus free speech conflict currently taking place on social media as the forums being used were suspended by Reddit and Facebook during the battle.

First, some background. Most individual investors buy mutual funds or ETFs in the their 401(k)s or brokerage accounts expecting that they will increase in value over time as the economy grows and pays some dividends or gains along the way. Serious investors may also pick individual stocks based on the likelihood that those particular businesses are stronger than the overall market and will outperform. Sophisticated investors and funds also know that there will be corrections along the way and try to profit from market downturns as well. Some hedge funds specialize in finding businesses that seem weak and will “short” their stock to take advantage of an expected drop in price, by borrowing stock they don’t own and selling it. They expect that they can buy it later at a lower price and keep the difference as profit. They have to maintain enough cash or “margin” in their accounts to cover buying back the stock. If the price rises enough, they may get a “margin call” requiring them to either buy back the shorted stock or add more cash, creating a ‘short squeeze”.

What happened? Notable funds like Melvin Capital and Citron Research placed substantial shorts on a group of stocks that had been hit hard by the Covid-19 lockdown including Gamestop (GME), AMC theaters, American Airlines, Bed Bath & Beyond, etc. expecting them to drop greatly in price or even go bankrupt. (In GME’s case more stock was shorted than exists, which is a whole other topic).

The Reddit WSB group saw that there were huge short positions in these stocks making them especially susceptible to a short squeeze. Price is moved up by the purchase of stocks or calls. Market makers sell calls to bullish investors and then buy the actual stock to hedge their risk. By coordinating lots of small purchases of stocks and call options on GME stock, r/WSB members managed to quickly drive up GME’s price forcing the hedge funds to free up cash or buy back stock to meet their margin calls. It was literally thousands of Davids attacking Goliath. At one point the hedge funds were supposedly down $3 Billion or more. Hoping GME would drop later and recover some of their losses, the funds sold other assets which caused much of the market drop on January 29th as cash was freed up.

Trying to clamp down on the mania, Robinhood, TD Ameritrade, Interactive Brokers and others placed various trading restrictions. Robinhood only allowed investors to sell existing positions or buy very small amounts of stocks and calls in 13 high fliers effectively stopping the runup. Wall Street and Big Tech worked together, Reddit and Facebook shutdown r/WSB forums for awhile trying to limit their communication at this critical moment. This allowed Melvin Capital and Citron Research to cover their positions overnight albeit at a heavy loss. Robinhood had to get an infusion of capital from Citadel which provides 40% of Robinhood’s revenue and also owns Melvin Capital to meet their statutory requirements. The r/WSB group and even lawmakers cried foul as individuals were cut out of trading while the large players continued unwinding their positions prompting Congressional Investigation.

The r/WSB group has spoken out that this movement is not primarily about making money even though some have bragged how they have multiplied their investment many times over. They are angry that Wall Street and big tech have profited handsomely, as families and individuals suffer especially during the Covid lockdown this last year. They feel the system is rigged against them and coordinated actions taken by Wall Street and big tech confirmed that last week. Some have lost hope and YOLO (You Only Live Once) has become a rallying cry, so why not go for broke? In the end, some funds lost a bunch of money, other firms that already owned these stocks made money, and CEOs’ company stock climbed in value. AMC even raised cash by selling $304 Million in stock. There were some big winners and no doubt big losers among the retail traders. Many will leave Robinhood and perhaps other brokers that limited their trades.

What does this mean for the individual retail investor? It means we may see more market volatility going forward. For example, XRT, the retail ETF was down 8 percent on Feb 1st when GME dropped 60 percent, as it had become 16 percent of the ETF’s holdings during the runup. Long term buy and hold investors shouldn’t see an effect unless regulators over react and create a ‘fix’ that is worse than the supposed problem. Large firms are more likely to be quiet about their shorts or hopefully rules will be enforced that shorted stock can’t exceed the actual shares outstanding. If an investor wanted to speculate on a ‘hot’ stock (r/WSB or other) using money that they can truly afford to lose, a much safer way would be to find an ETF that contains the stock in question and buy the ETF instead. The reward won’t be as great, but diversification reduces the risk and you don’t have to worry about your broker limiting trading of that individual stock.

Call Options Explained:  A Call option gives the owner the right (but not requirement) to buy stock at a fixed price before a certain date. Example: GME is at $53.50 today, Feb 4th. Buying one GME Feb 12th 55 Call lets an investor buy 100 shares of GME for $55/share for the next week. Since GME is so volatile they would pay a huge premium of $13 per share for that right today. So GME must go above $55 strike + $13 premium = $68 in the next week for them to make a profit, otherwise they will lose money. Premiums would normally be much lower perhaps $1 or $2 depending on the stock’s volatility and the likelihood of reaching the strike price before the expiration date.