Has the stock market gone crazy?
Understand how an Internet forum changed the rules for trading
The financial markets went into turmoil last week when impopular stocks such as Gamestop ($GME), a decadent game store chain in the United States, and AMC ($AMC), a movie chain severily hit by Covid-19, were suddenly hitting humongous appreciations.
$GME shares, for instance, went from $19.95 to $347.51 in just two weeks. If you had invested $1,000 on January 12, you would have $17,400 in your trading account on January 27.
For the untrained eye, this could have been just another month in the volatile stock market and perhaps Gamestop had announced some excellent news to boost the stock. Actually, what was behind the rally is something that will change stock markets forever.
Understanding what happened
To understand what is happening, you need to understand what a 'short' is in trading. A 'short' is when you borrow a stock from a broker and sell it immediately at its current price. Then you hope the stock's price falls such that you can buy the stock back at a lower price and return the shares you borrowed to your broker, but keeping the difference.
Example: Let's say I want to short stock ABC which has a current price of $100. I borrow 1 share and sell it immediately at $100. I have $100 now but I owe my broker the 1 share I borrowed. Then let's say the price of ABC drops to $20. I now decide to 'cover' (buy it back) my short position and buy 1 share at $20 and return the 1 borrowed share to my broker. I made $100 when I sold and only had to pay $20 to buy it back lower, so my profit is the $80 difference.
But now let's say that instead of the ABC price dropping to $20, it goes up to $150. I still need to return the 1 borrowed share to my broker, except now it going to cost me a lot more to buy it back. If I buy it back at $150 so I can return the borrowed shares, my losses will be the $50 difference between selling at $100 and rebuying at $150. Since the price can rise indefinitely, my potential losses as a short seller are unlimited. At some point I have to buy it back to return the shares I borrowed. The more the price rises, the bigger my losses.
If you can't believe this is possible and legal under current laws, there may be milions of other people who agree with you.
Shorts are a speculative instrument that Hedge Funds use to make money on companies they dislike or bet against. Tesla, for instance, was the most “shorted” stock in the US until 2019 because investors never thought it would succeed. When Tesla stock appreciated dramatically in 2020, hedge funds lost many billions of dollars.
Now to the story behind Gamestop rally. A few weeks ago a redditor on r/ wallstreetbets noticed that a hedge fund had taken a massive amount of short trades against Gamestop. They convinced everyone on the thread to join forces and buy as much Gamestop stock as possible. This made the price rise and the hedge funds short position started to lose billions.
The losses even surpassed the $13.1 billion that the hedge fund was worth. Eventually, the hedge fund had to close their short positions and buy all the gamestop stock back at much, much higher prices, sending the price even higher still. This is called a 'short squeeze'.
Now the hedge fund is declaring bankruptcy, and the reddit thread is combing through other hedge funds with massive short exposure so they can short squeeze them into bankruptcy as well.
People x Wall Street
What happened was a spectacular inversion of roles fueled by crowdsourcing. The strategy usually used by large investors to make money for the hedge funds was then co-opted by millions of small retail investors to destroy the hedge funds and make money for millions of real people instead. Wall Street is saying that the public joining together in this fashion should be illegal, but really they just lost at their own game to the masses.
But wait, there is more.
During this mess, apps where millions of investors trade, such as Robin Hood, suspended transactions on these shorted stocks, due to pressure from Wall Street. Now everyone is pissed at the apps, from retail investors to hedge funds and politicians from the right and left.
In other words, the government is moving towards protecting millions of investors who had their rights curbed by the investment platforms and the name Robin Hood became a parody of itself.
Why should you care about this?
This story represents a paradigm shift that happens once a decade. It may well spark legislation to regulate hedge funds, investment apps or even extinguish the practice of short selling, which many think is predatory and unwarranted.
My main concern, though, is that this January 2021 event may spark the era of financial AI botnets, where state-sponsored actors unleash thousands of fake accounts on these investment apps in order to manipulate the stock markets automatically, and therefore rendering them totally unrealiable and rigged.
In my oppinion, the redditt fueled fight against hedge funds will mark the beginning of a large shift towards cryptocurrencies and AI powered stock markets.