“Dumb Money” upbeats “Smart Money”- 1

These terms were coined by financial media in order to differentiate investors in the market on the basis of access to information and the ability to act on it. It has nothing to do with intelligence.

Smart money” refers to large hedge funds, institutional investors, or mutual fund companies, whereas “Dumb money” refers to the average investor or retail/individual investor.

Generally, in the market, we have seen that “dumb money” follows “smart money”. But this time it was different. A group of retail investors gathered on the Reddit platform to beat the big players in their own game.

Maybe you have guessed till now, what am I talking about.

YES! I’m talking about GAMESTOP (ticker: GME) and many other stocks like Nokia, AMC Entertainment, American Airlines, etc.

Their share prices have sky-rocketed in the last few days. GME’s 1-year stock return is more than 8000%. And the surge in GameStop and other heavily shorted names hasn’t been all that different than the mania for marijuana stocks in 2018 and for bankrupt companies like Hertz global holdings. The stocks had been halted 40 times in the NYSE exchange, but couldn’t stop the run of the stock.

In this article, I’ll cover the following topics —

  • What is the business of GameStop and a brief peek into its financials?
  • Events that lead to the price increase of GME from $17 per share to $483 per share in the last few days.
  • Actions taken by different stakeholders.

Before we start let’s get familiar with two concepts i.e. short-selling and short squeeze.

Short selling is when an investor borrows shares and immediately sells them, hoping to buy them back later at a lower price, return them to the lender, and pocket the difference. Investors believe that stock declines in value. In order to cover the position an investor buys the shares from the market and returns it to the lender.

If the price in the future declines that it’s profitable for an investor and loss in case the price of the shares went north. Short selling is risky because it has limited upside, but unlimited downside.

Short squeeze is when a mass of investors looking to cover short positions start buying at the same time. The buying pushes the share price higher, making short investors accelerate their attempts to cover.

In a financial market, there is generally the concept of risk limit on short trades, which states that in case there is an X% of decline in the trade, then cover the position or close out the position.

So when the stock prices of GME were increasing, fund houses might have been forced to cover the position or put more collateral in order to cover the loss. It pushed the GME stock price higher. The higher the stock price goes, the more short sellers are forced to cut their losses by buying back the shares they sold. And their frantic buying drives the price even higher, forcing other short sellers to follow their lead.

Short squeezes only happen when a lot of traders have shorted the same stock.

A short squeeze is not new in the USA stock market.

It started in 1902 which was related to the New York railroad business.

In October 2008, a short squeeze triggered by an attempted takeover by Porsche temporarily drove the shares of Volkswagen AG on the Xetra Dax from 210.85 Euro to over 1000 Euro in less than two days, briefly making it the most valuable company in the world. Then Porsche CEO was charged with market manipulation over his role in the event and ended up being acquired by VW instead.

In 2012, the SEC charged Philip Falcone with market manipulation in relation to a short squeeze on a series of high-yield bonds issued by MAAX Holdings.

Last year in 2020, it was about Tesla.

And, 2021 is a year of GAMESTOP!!!

Let’s start!!

GameStop Corp established in 1996 is a U.S. multichannel video game, consumer electronics, and services retailer. The company operates across Europe, Canada, Australia, and the United States. It has approximately 5,500 stores across 14 countries.

The world’s largest videogame retailer has been hit as customers moved to digital downloads of console games, coupled with intense competition from videogame streaming services.

An investor can either take a long or short position in the market. In this case, investors were optimistic and pessimistic due to the following reasons.

But this time short positions exceeded the shares outstanding. Usually, you don’t have to disclose your shorts — but these were ‘listed put options’ so some clever Redditors discovered the position. Its process looks like this —

If you see here, the same shares have been borrowed and sold more than once. In case it continues total short interest would eventually exceed the number of shares outstanding.

How it all started?

Roaring Kitty, as he’s known on YouTube and Twitter, has been talking up GameStop stock since taking a long position in it a year ago, when he noticed it was among the most heavily shorted stocks on the market.

On Reddit, where he posts as u/DeepFuckingValue, he’s spent months posting about it to the r/WallStreetBets subreddit. Earlier people used to think that he is crazy, but as time passed, more and more people started taking his advice seriously.

Everyone in that group started buying shares or calls option for GME which reduced the supply of the stock in the market.

And, when hedge fund managers went to the market to cover their position, they saw that there is a shortage of stock. But the clock was ticking, they had to purchase the shares from the market at any cost.

Actions taken by the brokerage house, hedge funds, retail investors, and regulators

  • Brokerage houses like Robinhood, WeBull, TD, E-Trade, Interactive Brokers halted or limited the purchasing of these stocks on their trading apps also imposed new restrictions on who could buy GameStop, and substantially tightened their requirements for shorting stocks on margin (which means borrowing money to short stocks). Robinhood and other brokerage firms came up with an explanation behind the decision (in its post, Robinhood wrote that)

Amid this week’s extraordinary circumstances in the market, we made a tough decision today to temporarily limit buying for certain securities. As a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearinghouse deposits. Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment. These requirements exist to protect investors and the markets and we take our responsibilities to comply with them seriously, including through the measures we have taken today.

  • Many hedge funds especially Citron Research, one of the most vocal firms to take a short position against GameStop, announced that it would stop publishing short-seller reports after it logged a 100% loss on some GameStop positions.
  • Retail investors consider trading halt as a conspiracy against them. They believe that after receiving orders from the hedge fund houses, brokerage firms suspended or halted the trading from the platform. The retail investors filed a lawsuit against them.
  • The Securities and Exchange Commission (SEC) said that they will be monitoring the recent volatility in the market. They are also working with regulatory partners to identify and pursue potential wrongdoing.

In the second part of the article, we will cover the following segments -

  • The reason behind such a rally.
  • Are there any ways to prevent such events in the future?
  • Can this happen in the Indian stock market?

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