A hedge fund drama is now dissolving on Wall Street as seasoned hedge funds are being pushed out of their short positions by “amateurs”. For once, retailers beat Wall Street in their own game and are winning by far.
It all started with WallStreetBets – a subreddit group that acts like a trading forum where attendees discuss stocks, options, and tips and stories about trading on the stock market. WallStreetBets was founded eight years ago and had around two (2) million members, but that has doubled in the past week.
It all started with a company called GameStop (ticker $ GME), a favorite with hedge funds that specialize in shorting stocks. When selling a stock short, the seller is obliged to make 100% of the investment if the stock goes to zero – in plain language, if the company goes bust or goes bankrupt.
The problem for most of these hedge funds is that WallStreetBets decided to take on the other side of the trade. And the difference is huge – while the losses on long positions are limited to the downtrend (e.g. the stock cannot go below zero), the losses for the short sellers are capped indefinitely.
How it works – there is both a short squeeze and a gamma squeeze in the game, a deadly combination for short sellers.
What is a short press?
When short sellers bet against a stock, they borrow stock from the brokers with a promise to return the stock in the future. The aim is to make a profit when the stock price goes down.
For example, if a short seller sells a stock for $ 50 and the price rises to $ 40, the seller may decide to take profit. To do this, the short seller closes the short position by returning the shares to the brokers and making a profit of $ 10 on the difference.
But what if the price goes up and not down? Here comes a short press into the picture.
Let’s say the stock price increases from $ 50 to $ 100. When the short sale of the short asset increases rapidly, the short seller is forced to cover the short position by buying the stocks in the market and returning them to the brokers. More specifically, the short seller adds fuel to the fire, and so the price continues to rise.
In other words, the short seller is forced to exit the trade by buying the stocks to cover their shorts. In the case of GameStop, the WallStreetBets group created a mark-to-market hole of $ 5 billion in the pockets of short sellers yesterday. And that was only yesterday.
The epic short squeeze also benefited from another thing that went wrong with hedge funds – a gamma squeeze.
What is a gamma squeeze?
A gamma squeeze is part of the “dark” world of derivatives trading. Why dark Because derivatives were responsible for the great financial crisis of 2008-2009. One of the principles WallStreetBets members stand for is: How come investment houses were bailed out after the crisis while regular Joe was paying the bill? And now the same weapons are being used to “punish” the rich on Wall Street.
Before going into the gamma squeeze, it should be mentioned that this is a phenomenon that is part of options trading. Options are derivatives that fluctuate due to the movement of the underlying asset (i.e. the stock that has been trimmed by hedge funds). The thing about these options is that while they belong to a different market, they have an indirect impact on the actual market price of the underlying asset. Here’s how.
Options are either call or put. When you buy a put option, you expect the price of the underlying asset to fall. When buying a call option, expect an increase. Remember that these are nothing more than contracts and the cost of entering into the contract is called a premium.
However, if you are buying a call option (i.e. expecting the market to move up), someone has to sell that option to you and introduce the market maker to you. The market maker thinks twice about the risk they are taking, especially if the price of the stock is actually moving up. Therefore, the market maker will hedge his exposure as the market maker will suffer a loss if the price rises above the strike price.
To hedge against such a scenario, the market maker enters the actual market and buys some stocks for himself. The more the price rises, the more the market maker also buys. This is the indirect effect of an options contract on the actual price of the underlying asset.
Market makers use the delta, a measure of how much the price of an options contract moves relative to a one dollar movement in the actual stock. Gamma represents the rate of change. The more delta and gamma increase in a gamma squeeze, the more the market maker is forced to buy the stock on the market.
Breakdown of a squeeze timeline
It all starts with someone (i.e., hedge funds) being involved on the short side of a company. If other traders believe the company is worth more than its current price, they may choose to buy the actual stock, buy call options, or both.
With every $ 1 increase in the stock price, the short sellers suffer from both a short squeeze (short sellers have to buy the stocks to return them to the brokers) and a gamma squeeze (market makers have to buy the stock to hedge) against that Risk of exercising the option in the money).
What does this mean for investors?
Suddenly the retailer rules the market. When 2 million traders with small accounts act together, they act like a huge fund of their own, with enormous capital and resources.
Investors should care because for the first time retailers could permanently change the stock market. We may be at the dawn of a new era of investing where power is shifting from institutions to individuals.