The Reddit Phenomenon – What You Need to Know
Normally I keep my blog posts related to core financial planning topics that can help you better understand the personal finance landscape but every now and then something happens that needs to be addressed. Over the past several weeks we have seen one of those examples, the Reddit short squeeze trade. This post will give an understanding to what happened, what it means to you and discuss if you need to jump into the action.
To start, we need to understand what a short squeeze is. 98% of the activity in the stock market is people going long on an investment. When you buy a share of Apple or contribute to your 401k plan you are going long on those assets. You are buying a share at the current price in hopes that the asset price will increase over time providing you a gain on your investment. Shorting an investment is just the opposite concept. You do this when you think a particular stock or fund will decrease in price. This is normally done when someone thinks a particular company is in trouble or if they think a recession or other economic downturn is coming. To do this, an investor borrows a share of stock from their broker and sells it at the current market price but they are required at some point to purchase that share back from the broker. This type of activity is most frequently done by hedge funds and not individual investors.
A short squeeze occurs when those that have shorted the stock feel pressure about their position because the price of the stock is heading up and not down like they had hoped. Remember, the person shorting the stock has to buy a share at current prices to make their broker whole. So the more the price goes up the more money the person shorting the stock is at risk of losing. This pressure can lead them to buy and cut their losses.
In this most recent scenario, let’s look at what happened with GameStop (ticker GME). GameStop is a company that relies on physical stores to sell video games and related accessories. This was a solid business years ago but like what happened to Blockbuster when Netflix came around things have gone online and many of these games are now downloaded or streamed. GameStop has continued with its existing business model and as a result has seen a steady decline over the past few years in revenue and profits. Revenue is down almost 30% since 2016, net income has gone from $500 million in 2016 to negative in both 2019 and 2020, cash flow has gone from over $500 million in 2016 to a negative $250 million in 2020, and finally, this has led to a decreasing amount of cash on the balance sheet. The stock price has reflected this business downturn going from about $29/share down to $4 in the fall of 2020. This all points to a company that is in a slow death spiral. They have an outdated business model for their industry and declining business performance. This is the type of company frequently targeted by short sellers because unless the company overhauls their business it appears they will continue to slowly decline and eventually go the way of Sears and JCPenney. So selling a stock even at $4 and then buying it back at mere pennies results in a great trade and huge return for that investor.
Now, here is what happened that makes this story fascinating. A group in the sub-Reddit community WallStreetBets got together and decided to go against these hedge funds and make some money along the way. This Reddit group is normally thought of as retail investors, in other words, non-professional investors. GameStop actually started ticking up in the fall of 2020 going from $5 to $19 by the end of the year. Then things got crazy. Below is a chart of how the stock has performed since January 11th. In that first week the stock went from $20 to $39, that’s a huge move for any stock in one week with almost a 100% increase. The following week saw the stock increase to $77, another 100% return. Then the week that made this a news story.
By closing price:
Jan 25th – 76.79
Jan 26th – 147.98
Jan 27th – 347.51
Jan 28th – 193.60
Jan 29th – 325.00
Those are absolutely crazy moves in a single stock in that short of a period of time. The stock actually reached an intraday high of $483 on January 27th. While GameStop had made a somewhat notable personnel move that might bode well for the company, the future prospects for the company did not suddenly improve by 1000%. This was move was not based on the fundamentals of the company. It was solely driven by an artificial demand intended to punish those who had shorted the stock.
So how did the short squeeze work on the hedge funds? As the stock price went up some short sellers were forced to cover those borrowed shares and buy them back at current market prices which had gone to almost $500. This is obviously a huge loss as they had borrowed those shares most likely at a price under $20. Melvin Capital was the poster child for this as their hedge fund lost 53% of its value just in the month of January due to its 5.4 million share short position in GameStop. This loss totaled $6.5 billion for the fund. Not all hedge funds got beat up on this though. Senvest got in on the action and actually made $700 million.
After the peak
Now here is the thing with a bubble like this, it has to burst. Almost as quickly as the rise of the stock price was the collapse. As the price skyrocketed the new people buying in at higher prices were tying up more of their capital. The only way they can make money on their investment was for more new people to come in and agree to buy in at the artificially elevated or even higher price. Once that well runs dry the price starts to fall and it fell fast. Since the mania of the week of Jan 29th the stock has fallen back to $51, a drop of 89%.
Who were the winners?
Those that started buying the stock last fall as it rose to $20 and were able to get out during the huge push upward are the real big winners here. Even those that bought in on say Jan 25th or 26th and sold within a couple of days made a tidy profit. Lastly, and ironically, those who shorted the stock as it reached its peak did very well as within 10 days later the stock settled into a $50-60 range.
Who were the big losers?
As mentioned, Melvin Capital is the headliner of this group. Unfortunately, some of these retail investors were left holding the bag as they bought in at the peak, thinking the party would continue, only to see it break up much earlier than they thought. This was the dangerous part of this game. Like a Ponzi scheme, it works only as long as new buyers come in agreeing to pay a higher and higher price but eventually you run out of people to buy at a higher price especially when the stock price isn’t based on anything tied to the company’s performance. When people sold and took their profits the stock price dropped like a rock.
Robinhood also falls in this camp. Robinhood is the preferred trading platform for this new wave of retail investors. The problem was they had issues dealing with all of the activity and halted trading of certain stocks when the mania was at its peak freezing out stock holders from getting out of their positions as prices were falling. They took a major PR hit but it remains to be seen if they actually lose investors off their platform.
Did this impact me?
Probably not. While this story got a lot of attention the companies involved are all fairly small in terms of impact on the overall market. So if you own an S&P 500 fund which is all larger companies there was no impact. If you owned a small or mid cap fund you may have seen a small impact as these funds typically hold hundreds or more individual companies within the fund and the movement of one company won’t have a material impact on the entire fund.
Should you get in on future Reddit trades?
While GameStop was the highest profile example of the power of the Reddit trade it was not the only example. There were others and will continue to be more. In fact, as I write this today there has been a major move pushing marijuana based stocks higher. To come out on the right side of this requires a good degree of market timing which is an incredibly difficult thing to do. You might catch the upswing and make money or get caught holding the bag when the euphoria wears off. And with the type of price swings we saw in GameStop those losses could be substantial. Just don’t make the mistake of assuming a given stock price will continue to go up as part of a movement.
What do you do moving forward?
If you have a long term investment plan that helps you reach your goals, stick with it. Don’t get thrown by the white noise these types of trades create in the news or get caught up in the rush of a get rich quick trade. Wealth is built over time, not in a week and these types of stories always have someone who is on the wrong end of things. The news will move on and you won’t hear much about the regular investor who lost $10,000 on GameStop because that doesn’t get anyone’s attention even though to that regular investor that $10,000 means a lot.
This has been a fascinating story to follow and there will continue to be other episodes of this but none may quite grab the spotlight like GameStop did. I hope this helps you understand what happened, what the fallout was, and what it means to you.
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