r/wallstreetbets is a subreddit with over 6.2 million members. Notorious within the online trading community for being a harsh and profanity-filled forum, it primarily consists of discussions and discourse on high-risk, high-reward trading.
Having garnered more media attention in the last week of January 2021 than most subreddits ever do, a lot of people unacquainted with the story were left scratching their heads as an amalgamation of stock market terminology, internet slang, and memes hit mainstream media. So what happened exactly?
To the layman, the dynamics at play here are nothing short of a dizzying medley of un-understandable terms. But a good way to understand is by starting with what shorting is—and how a bunch of amateur Redditors were able to outsmart a bunch of Wall Street professionals.
Shorting is a trading technique in which sellers borrow shares of stock from an investment institution with an interest rate and then sell it to other investors. Once that is done, the seller is left with no share but still is bound to return it to the institution. So the seller waits till the price of the stock drops, buys a share and returns it to them. The seller meanwhile still has the money they earned by selling the share and thus earns a profit of that much amount.
Shorting is a swift and easy way to make a quick buck—but only if the person has anticipated the fall in stocks at the right time. As effortless as it seems to make a profit, it is even easier to suffer a loss.
Supposing the seller’s prediction regarding the fall in stock values is incorrect; not only does the seller have to pay the interest they borrowed the share at, but also buy a new share at a higher stock value in order to return it.
This results in a heavy loss for the seller and since there is no fixed limit as to how high a stock’s value can rise, there is no cap on the loss that can be faced as well.
Another essential term that needs to be understood in order to make heads and tails of the whole GameStop fiasco is a hedge fund.
What do you call a group of people looking to make a quick buck, presided by a person making a quick buck off their quick buck? A hedge fund, of course!
A hedge fund consists of a group of investors who generally have pre-existing agreements about the aggressive and risky nature of the investments they’ll do, and a ‘fund manager’ that presides over the hedge fund by implementing its investment strategies, as well as supervising its activities.
Melvin Capital, one such hedge fund, had been indulging heavily in shorting GameStop stocks. That would ultimately prove to be their undoing, as members of r/wallstreetbets noticed this and started buying a large amount of GameStop shares. The people in charge of Melvin Capital watched in horror as they saw the sheer amount by which the stock prices had gone up. In the month between December 28, 2020, and January 27, 2021, the price of the GameStop share went up from $20.88 to $347.51—that’s an increase of over 1500%!
The folks over at Melvin Capital were in dire straits. With debts mounting up, they were forced to buy even more shares of stock to cover their losses. They soon realized, however, that it’s never that easy in real life. Their purchasing had led to an even bigger increase in the stock price–causing their debts to mount up even further. To quote a business major who was asked to explain the whole scenario, this is what is known as a short squeeze.
In the end, the war between Melvin Capital and Redditors turned out to be very short-lived. Reportedly registering over 30% losses, all it took was some daring anonymous users on the internet to almost destroy a (previously) wildly successful hedge fund.
A spokesperson of Melvin Capital later went on to say that the rumours of the company declaring bankruptcy were ‘categorically false’.
Members of r/wallstreetbets were then dismayed upon hearing that over $3 billion were used in shoring up the company’s finances—supplied by two other hedge funds known as Citadel and Point72 Asset Management.
The fallout of the short squeeze was almost as eventful as the original. Not only was the wallstreetbets Discord server banned for ‘hateful speech’, but the subreddit itself experienced an immense influx of members—nearly doubling in amount despite having been temporarily set to private.
Trading app Robinhood went as far as to restrict the purchasing of the share—only allowing selling to take place.
The question that arises out of this entire situation is: do the short-sellers deserve it?
Hedge funds aren’t exactly well-loved due to their exploitation and ruthless disregard for businesses that don’t live up to the economic standards. There is also proof that shorting can accelerate the fall in stock values.
However, it is not concrete that short selling is always successful and the stock market is an unpredictable and never-ending race that can never be pinned down.
With the onset of this incident, the ambiguity of hedge funds has been brought to light with government organisations and the U.S. Securities and Exchange Commission (SEC) is stepping into play.
Written by Tanya Jain and Rushil Dalal for MTTN
Infographic by: blog.freetrade.io
Featured Image by: thebalance.com
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