Robin Who?

With 2 days left in the first month of 2021, it seems there is no plan in sight to slow down the insane headline trend from 2020. So far this year has brought us a run on the capital, another attempt at impeachment, an inauguration, and that brings us to this week. In what some have coined “The Reddit Revolt” we have witnessed a never before seen intersection of social media and the financial markets. Seemingly every time you open your phone to look at Twitter, Instagram, even Tik Tok at this point, you cannot avoid headlines about Gamestop, AMC, and a few other individual stock names. Millions watched their screens as we saw these positions absolutely soar to levels that had even the most astute financial professionals scratching their heads. Given the inquiries we have already fielded regarding these happenings this article will seek to lay out what happened, how it happened, and what lessons it may have produced.

What Happened

google search traffic for “wall street bets” ytd

For many years there have been an increasing number of retail investors who share investment ideas online. Not limited to stocks, but sharing ideas about crypto currency, options strategies, forex, you name it. The most notable “idea exchange” would be Reddit. For those unfamiliar, Reddit is a massive online forum containing sub reddits for basically any topic you can dream up. The main source of the trading action we have seen in the past few weeks can be traced back to a subreddit called Wall Street Bets (WSB). For many the gamestop conundrum is the first time they have heard of the Wall Street Bets subbreddit, but in fact it has been around since 2012 and has pretty deep ties to internet culture. The subreddit is responsible for some modern day investing phrases like “HODL" (Hold on for Dear Life), “YOLO (You only life once) and “To the Moon.” The group (with 5 million members or “degenerates” as they self proclaim) has the reputation of an appetite for high risk, high conviction trades or “bets” as they call them. As retail trading became increasingly popular (see my article from July about exactly this), so did this community.

At some point over the past few weeks companies like Gamestop and AMC garnered a ton of attention on the WSB platform as companies that had eye popping levels of short interest. Meaning these companies had an extremely high amount of funds who were selling short shares of those companies. After choosing their targets the forum organized and began to absolutely pile into shares of these companies, sending them hyperbolic. Gamestop, a company that has been flirting with bankrupycy for years, saw its shares go from the mid $40’s last week to over $300 per share. The more they bought shares the more we saw the share price go up. Sooner thereafter, traders on the sidelines, who likely had no affiliation with WSB whatsoever, saw the momentum and couldn’t help but jump in themselves, driving the price even higher.

What continued to develop can only be described as the textbook definition of a short squeeze. For those unfamiliar here is what happens during a short squeeze. In order to be familiar with a short squeeze, lets cover what short selling is first.

Short Selling

Short selling (shorting) is the trade an investor would make if they believe the price of a company will decrease. In order to do this, you will actually “borrow” shares of said company to sell. By selling “borrowed shares” you are hoping that the price of the shares that you sold decreases, because then you can turn around and buy

those shares back cheaper and pay back the investor you “borrowed” your shares from. Still having a hard time following? This is how I was taught it as a kid. Imagine you, for whatever reason, suspect the value of a baseball card is going to go down. You don’t own this card, but you expect the value of it to go down. You borrow said baseball card from a kid in your school and go and sell it to somebody else for $10. Now, you still owe that kid from school a replacement card. Assuming your bet was correct and the asking price for that card goes down you can now go out and buy said baseball card for say, $4. You go buy that card for $4 and give it back to the kid you borrowed it from and you are square. You sold the original card for $10, bought the replacement for $4, you are up $6 (but you might be a bad friend in this example.)

Short Squeeze

A short squeeze occurs when the price of a company that has a lot of short interest begins to go up. Remember, if you are shorting a stock you have sold a “borrowed” share. The major risk here is that the stock begins to increase after you have sold it short. Since there is no limit to how high the share price can go, the short seller’s potential losses are theoretically unlimited. Think of our baseball card example. If you sold your borrowed baseball card for $10, and for whatever reason those specific cards become in demand, you could see the price go to $15, $30, $100! You are on the hook for purchasing back a card to return to the friend you borrowed it from. This is exactly what we saw happen with the Gamestop trade. As mentioned above, Gamestop had attracted a large amount of funds who had shorted their stock. This week, when retail investors began buying into the company, the heightened demand caused the price of Gamestop to go up and up. Subsequently, the short sellers came rushing in to purchase shares themselves so that they can cover their own short position, in turn, causing the stock to go even higher. It was an absolute rush for the exits on the short trade. What resulted was that many of the funds who were short Gamestock took tremendous losses at the hands of the retail traders.

Enter Robinhood

The preferred trading platform for many of the new age retail investor is an online brokerage called Robinhood. I mentioned Robinhood a few months ago in THIS article. In July, at the time of that writing, Robinhood had about 8 million users. Fast forward to today and that user figure is closer to 13 million users, with the app sitting #1 in the app store for many weeks. Robinhood, as the name would suggest, was founded with the mission to “democratize finance for all.” For most of Robinhood’s existence they have done pretty much that, and their user base is a testament of it. Robinhood made headlines this week after they suspended the purchasing of stocks like Gamestop and AMC in the midst of their rallies. The platform left users scratching their heads as they watched positions soar higher and higher with no opportunity to get in on the action. There are a number of reasons to explain why their CEO, Vlad Tenev, decided to make the decision that should probably be reserved for a separate article. However, the decison did manage to have Donald Trump Jr, AOC, Dave Portnoy, and Mark Cuban to come together and speak out against the company. However, you may recall that this isn’t the first time Robinhood traders have had problems trading during a big day. Robinhood has since resumed trading of the positions, but only time will tell how much damage this decision caused to the platform.

The Lessons

• Do your research before buying

  • Just because a company is flying off the charts does not mean that it is a good investment. In fact, it typically may be a signal to stay on the sidelines and see how it plays out.

• Understand the difference between investing and trading

  • Investing is the long term systematic accumulation of assets meant to build long term wealth over time. Trading is a quick bet to make a profit off of a perceived move a company will make. Don’t let a trade trick you into thinking it’s an investment, and don’t always expect an investment to perform like a trade.

• The investing environment is shifting

  • The rise of the retail investor, the popularity of Robinhood, and the Gamestop saga represents another real world example of the shifting of the investing environment. One of my favorite economists, Brian Wesbury, perhaps had the best take on the ordeal. With M2 money supply exploding, the retail investor now has more cash in their pockets than ever before. Gamestop will not be the last meme stock, this will happen again.

• Diversify

  • It can be very tempting to jump into any of these “meme stocks". Gamestop wasn’t the first, and it wont be the last, but please recognize your actual risk tolerance and be aware of it before piling into trades like this. Know the place within your investment strategy for trades like this (if any) and be centered around that, don’t let the position get disproportionately large in your account.

• Know when to take a gain

  • One of the best strengths a trader can have is knowing when to take profits. In even a standard investment this can be a tough thing to do. However, when moves are drastic like with what we have seen with Gamestop, the ability to take a gain and move onto the next one can be an even harder thing to do. This is my friendly reminder that stocks do not always just go up. Especially in the situation of a short squeeze. These are, by definition, a short lived phenomenon, let’s not forget that at the end of the day Gamestop is a nearly bankrupt company. To the people that have made money on this trade I say kudos, I am genuinely happy you were able to get in on the action. To those who are still holding positions in this, I would be very careful with how much longer you let pass until you look for the exits yourself. You might be up big right now, but this will likely end just as quickly as it began! When it comes to trading, there is no greater psychological warfare than to know you could’ve gotten out of a position at a massive profit, only to see yourself back to even on the screen - believe me.