Wall Street Outsiders versus the Hedge Funds

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The investment world was convulsed last week when at least one hedge fund (Melvin Capital) lost billions of dollars.

The sudden, massive losses happened when a tidal wave of independent individual investors, spearheaded by posts on Reddit.com, triggered a short squeeze that torpedoed the hedge fund.

For those of you unfamiliar with a “short squeeze,” let me explain. Most stock market investors “go long.” That means that they buy a stock and then hope to sell it later at a higher price.

Short sellers do the same thing except in reverse sequence—that is, they sell first, hopefully at a high price—and then buy later, hopefully at a lower price. Whereas “long” investors make money when the price rises, short sellers make money when it falls.

A short squeeze happens when increased buying volume starts to push the price higher.

Every dollar the price rises inflicts losses on short sellers. Because the only way to sell a stock short (that is, to sell a stock you don’t have) is to borrow it from a broker, the short seller not only pays interest on the borrowed shares, but as the price rises, he is legally required to transfer more money in his brokerage account to make sure that the lender doesn’t end up eating the losses.

These are the infamous “margin calls.” The more the stock rises, the larger the margin calls and, thus, the more the short sellers are “squeezed.” The only way to stop losing money is to exit the short position by buying back the stock.

But guess what? Buying back the stock adds to the buying pressure, pushing the price of the stock up even more, causing more short sellers to capitulate and buy back their shares. It’s a vicious cycle that can lead to a buying frenzy.

That is exactly what happened last week. The stock of a company called GameStop Corp., which had been trading at under $20 per share for ages, rose to over $400 per share in just a couple of days when an unorganized gang of individual investors—the “Reddit mob”—bought lots of GameStop’s shares.

This triggered a massive short squeeze that caught Melvin Capital off guard. Melvin’s strategists apparently had no exit plan in the case of the market turning against them, so they got roasted by the short squeeze, suffering massive losses.

One interesting aspect of this debacle is that the number of shares of GameStop that had been sold short reportedly exceeded the total number of shares in existence.

That means that some sellers were short the same shares at the same time. I’m not sure if that is even legal, but surely federal regulators need to look into that anomaly.

The individuals who bought GameStop made huge amounts of money—the money that the hedge funds lost—from the short squeeze that they had caused.

We shouldn’t feel sorry for the hedge funds. They only allow high–net worth individuals to invest with them, because they know that the investment techniques they use—leverage, derivatives, short sales, etc.—are very risky.

Thus, when a massive loss actually materializes, there is nothing unfair about it. It is simply the consequence of the risks they deliberately took.

However, instead of letting the short squeeze take its natural course and eventually come to an exhaustion point, at which the stock price would likely collapse, thereby inflicting huge losses on those still holding the shares (the “longs”), the so-called powers that be in the financial world intervened and tried to check Melvin’s losses.

We probably don’t know yet who all these “powers” are, but we do know that they included brokerage firms that arbitrarily limited the number of shares of GameStop and certain other securities that individual investors were permitted to buy.

This was designed to halt the short squeeze and so prevent individual investors from making more money at hedge funds’ expense—essentially changing the rules of the game in midstream, rigging the market in favor of the wealthy Wall Street insiders.

Think about it: When small investors lose their shirts by placing unwise investments, do brokerage firms, hedge funds, big banks, etc., come to their rescue? Not a chance.

Yet when the big boys were losing their shirts, their Wall Street pals rushed to their aid. In a battle between man-on-the-street Davids and Wall Street Goliaths (hedge funds), the establishment clearly favored Goliath.

This episode is reminiscent of the “too big to fail” syndrome that was so prominent in the Wall Street bailouts back in 2008. No wonder people despise Wall Street. Who can blame them?