Robinhood and the Short Squeeze

By Alfie Davies, Equity Risk Analyst at Kings Investment Fund

The past few weeks have witnessed a number of apparent attacks on short-selling hedge funds, causing a short squeeze in a number of equity markets. Who is responsible and what actually happened?

Short selling can be defined as a bearish market position whereby investors hope to profit from the loss of value in a security [1]. This entails using margin to borrow stock, and selling this borrowed asset in the market, before repurchasing at a lower price following an actual or expected loss of value.

Many have questioned the ethics of short selling [2] including Elon Musk, who in 2019 called for a total ban on short-selling after referring to short-sellers as ‘value destroyers’ [3]. The practise has been banned in the EU at various stages of elevated market volatility in order to stabilise markets, including during the 2020 Coronavirus pandemic [4]. Despite ethical concerns, the practice provides liquidity and increases the efficiency of financial markets, whilst levelling markets during heavy bullish runs [5].

If market prices rapidly rise significantly above their expected prices, this can cause a short squeeze – the snowball effect that causes prices to rise further. Short sellers are caught out by the price movements and scramble to purchase stocks that they are required to deliver, in an attempt to cut their losses [6]. The increased demand further drives the price up, resulting in stock prices becoming extremely overvalued, which is what has been occurring in the markets this week.

GameStop, a US ‘video game, consumer electronics and gaming merchandise retailer’ [7] has become the epicentre of attention and has triggered alarm bells for a number of short-selling hedge funds this week. Despite recording a loss of $795m in 2019 [8], its share price has ballooned over 1600% since the start of 2021 [9] including a mammoth 120% rise on Wednesday (27th January). This meteoric rise was clearly not caused by investors discovering hidden value in an undervalued stock, rather by who analysts have described as ‘tech savvy young day traders’ [8]. It has been reported that an ‘army of social media day traders’ are using low-cost trading platforms such as Robinhood – an unofficial stock trading app offering ‘exotic investment instruments such as options’ [10] for minimal fees.

[GameStop (GME): Source]

Online discussion forum Reddit has been a catalyst in the astronomical returns of equities such as GameStop in the past week. The forum r/wallstreetbets is used as a platform for amateur traders to share their positions, using it as an opportunity to ‘brag about outsize gains’ [11] or mock others for risky trading behaviour. The forum has been in existence for years but very much out of the spotlight until now. Following a number of users’ statement of intent to drive the share price of GameStop up, the posts gained internet notoriety and triggered a frenzy of buying which ultimately snowballed into a short squeeze.

Hedge funds, such as Melvin Capital, have been specifically targeted by these amateur traders who intend to inflict substantial losses [12]. In a stand-off between the two vastly contrasting parties, the question ultimately posed was ‘who will cave first?’ A statement on Wednesday by Melvin announced the covering of its short position, cutting their losses and ultimately admitting defeat. Whilst social media rumours spreading that the firm had gone bankrupt as a result were labelled ‘categorically false’ by a Melvin spokesperson [13], the closing of the short position has significantly exacerbated its $3.75b January losses [12], wiping out approximately 30% of its value [13].

Fund Managers and institutional investors have taken these developments incredibly seriously. Whilst amateur traders have rarely been considered a source of risk in the past, a Goldman Sachs Asset Management portfolio manager has described the need for investors to ‘rethink their strategies to contend with the growing influence of retail traders and the rising risk of shorting’ [12]. It is clear that the influence of these ‘day traders’ must not be taken lightly.

The unfolding of events has generated sufficient momentum and upset in the markets to warrant a statement from the White House Press Secretary, who on Wednesday announced that the White House and Treasury Department ‘are monitoring the situation.’ [14] It is possible that this will trigger an increase in monitoring or even regulation of social media forums to identify risks of short squeezes such as this.

This has been described as a conflict with ‘generational overtones’ [8] largely caused by ‘frustration that everyday investors are often locked out of lucrative opportunities, such as IPOs’ [15] according to a former hedge fund manager. Whilst hedge funds tend to ironically be the instigators of short-selling attacks [16], the tables have been turned incredibly unexpectedly. The divide between retail and institutional traders is wide. However, these events will likely widen it further and hedge funds will need to factor for additional levels of previously unconsidered risk.

Whether regulatory changes are made to social media forums to eliminate targeted trading attacks or not, it is clear that hedge funds such as Melvin will need to reconsider their strategies going forward. It is difficult to conceive how regulation would prohibit internet use for trading collusion, as it would be near-impossible to monitor effectively. However, short selling in its original form does not seem a viable option any longer, with one high profile short-seller warning others to ‘massively reduce your shorts or risk going out of business’.

The underdog retail traders appear to have won for the first major time against hedge funds in a David vs Goliath-like stand-off, but will we see this type of behaviour successfully again?



















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