Is short selling the best hope for cleansing the stock market of zombie companies? Or is it a plague of shadowy parasitic short-sellers destroying loved companies and fleecing retail investors? This new battle between Hedge Funds and online Reddit traders has started. And the Reddit traders taking on Wall Street
The power of ordinary people on the internet coming together in millions has been vastly undervalued, but not anymore. Social media non-influencers have been the ones influencing financial markets recently.
Melvin Capital, a $13bn hedge fund, has been left facing bankruptcy after an army of new age activist investors coordinating on Reddit pumped up the price of heavily shorted companies, like GameStop, tenfold in just a few weeks.
Two of the biggest investment banks, Goldman Sachs Group Inc. and JPMorgan Chase & Co. kicked off the U.S bank earnings season with trading and dealmaking revenue defying warnings from within the industry that good times couldn’t last.
Robinhood and some other trading platforms tried to restrict retail investors from trading specific shares. This raised fair questions about how retail and institutional investors are treated differently. Honesty and transparency of markets is a critical element of a free market. Any perceived discrimination against retail clients to benefit institutional clients has strengthened the resolve of the Reddit activists.
Despite the Reddit traders’ fury, the truth is that that it wasn’t Robinhood’s fault. They have rules they need to follow and this meant Robinhood had to restrict trading in those volatile stocks until it could increase its collateral held with the Depository Trust & Clearing Corporation, or DTCC, a clearinghouse.
A Clearinghouse is a good guy who promises to make good on all trades regardless happen regardless of what happens to an individual broker. They not only process and complete trades in an efficient manner, but they also help limit systemic risk.
A “squeeze” is when rapid price movements in a company’s stock force investors to make changes in their investment positions. The forced moves drive even more price changes and forced moves, creating a feedback loop.
A short squeeze is when a rising stock price forces people who had sold the stock short to buy back those shares, driving stock prices higher.
Because of the potential for a short squeeze, hedge funds who short stocks don’t just sell a stock, they hedge their shorts by buying long.
Related to the short squeeze is a gamma squeeze, and every once every few years, people get to learn all over again the meaning of gamma squeeze.
A gamma squeeze takes things one step further due to open options positions on the underlying stock and forces additional stock-buying activity.
In short, as the volume of call options on the heavily shorted stocks surged, the brokers who write options contracts hedge the contracts by buying stocks, sending those stocks ever higher. The short sellers then must cover their positions by buying the shares of those companies back. In order to fund those purchases, those short-sellers have to sell other long positions to raise cash.
This pressured the broader market and lead to a generalised sell-off hits the US markets.
The key thing to note about gamma squeezes is that they are very sharp, double-edged swords. Just as they can force buying pressure, they can also force selling pressure. As those options contracts are exercised/expire, the broker no longer needs to hedge against options position that no longer exists. That also reduces the buying pressure on the stock, which could cause the squeeze to reverse itself.
And when they reverse, the move in the opposite direction can be just as volatile as the initial short squeeze. Reddit traders beware.
When it comes to a gamma squeeze the best thing to do might just be to wait. Once it’s over, you can look through whatever wreckage remains. This the best time to determine whether it offers you an investment opportunity you really want to take advantage of for the long term.
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