Up until recently, a short squeeze wasn’t something most investors thought about very often. With short positions generally held by large institutional investors and squeezes tending to happen among penny stocks, the everyday investor isn’t usually exposed to these types of activities.
Due to a Reddit group known as WallStreetBets, that has changed.
Over the course of a couple of weeks, more investors were exposed to the concept of a short squeeze than ever before when WallStreetBets users waged a war on hedge funds, using the short squeeze as a tool.
The event has been called “the Big Short Squeeze.”
During the Big Short Squeeze, stocks of struggling companies like GameStop (GME), AMC Entertainment (AMC), Nokia (NOK), BlackBerry (BB), and several others screamed higher as the WallStreetBets group banded together to push short sellers out of their positions, sending these stocks toward gains in multiples in a matter of days.
But how exactly did that happen? Why would a Reddit group want to manipulate the value of stocks? Was the move even legal? And how will the Big Short Squeeze change the stock market as we know it?
What Was the Big Short Squeeze?
The Big Short Squeeze is a name given to the event in early 2021 where Redditors on the WallStreetBets subreddit flexed their investing muscles to show that the little guy will not be ignored in the stock market.
Taking aim at hedge funds that use their incredible financial strength when shorting stocks to drive share prices lower, WallStreetBets members decided that they would band together as retail traders to force things to go in the other direction.
The first stock targeted by the group of individual investors was the video game retailer GameStop. In order to push share values higher, the Reddit group — which had about 2 million members at the time — decided that they would band together and buy GameStop’s stock all at once.
While each individual investor didn’t have the buying power to cause any form of volatility shift in the upward direction, when a massive number of WallStreetBets members put their capital to work on GameStop shares all at once volatility ensued, and the stock rocketed upward.
Investment firms like Citron Research and Melvin Capital that had shorted GameStop lost massive amounts of money. Although Citron didn’t disclose their losses, Melvin Capital lost more than 50% of its assets in January, largely caused by the Big Short Squeeze.
Seeing that their efforts to thwart the plan of short-selling hedge funds worked, WallStreetBets began to tackle other heavily shorted targets in the stock market with a growing group of individual investors who were ready to put their money where their mouths were.
Soon, AMC Entertainment, Nokia, BlackBerry, Express, and several other stocks began experiencing short squeezes and gains in multiples of their own.
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Was the Big Short Squeeze Good for All Retail Investors Involved?
The David-and-Goliath battle waged by WallStreetBets on the big money in New York was designed to benefit the little guy while bringing the big guys to their knees, but did all retail investors involved in the move actually benefit?
Unfortunately, there were plenty of casualties.
In any short squeeze, share prices are pushed to extremes, generally becoming seriously overvalued as demand for shares skyrockets. But short squeezes are a momentum play and don’t last long. Once the momentum leaves, the stock falls and dramatic losses are experienced by those left holding the bag, as they say.
At the end of a short squeeze, the share prices had been so artificially inflated that the day traders involved began to leave their positions. When this happens, the declines are compounded by the masses jumping off the bandwagon, with everyone attempting to leave the same stock at the same time.
All this selling leads to dramatic declines in the stock price and a volatile race for the bottom that usually happens just as quickly as the run for the top took place. Because all the retail traders involved in the short squeeze won’t be able to exit their positions at the same time, those who were late to the selling trend when GameStop, AMC, and the others began to fall experienced painful losses.
Was the Big Short Squeeze Legal?
Whether all the activity around these short-squeezed stocks was legal is an interesting topic. The willful manipulation of any stock in the stock market, for any reason, is against the law. Moreover, any call to action to purchase stock by someone without credentials as an investment advisor, broker/dealer, or financial advisor without clear disclaimers puts the move into murky water.
Of course, there’s no rule against a group of investors banding together and sharing their ideas. Moreover, there’s nothing illegal about these investors choosing to buy and sell stock at any given time.
The question here is whether WallStreetBets users willfully manipulated the stock market in any way that hedge funds don’t. It goes back to the reason for the Big Short Squeeze:
What’s good for the goose is good for the gander.
If regulatory authorities were to target WallStreetBets Redditors for their involvement in the Big Short Squeeze, they also would have to go after every hedge fund that has ever banded together to use their clout to push stocks down by placing big bets against stocks.
So, although there may be a bit of a legal gray area here, the fact is that regulators have never taken action against moves like these in the past, and it’s not likely that any individual investor will face charges as a result of the Big Short Squeeze.
Disclosure: I am by no means an attorney. The above is my personal opinion and does not constitute legal advice.
How Did a Reddit Group Move the Stock Market?
It’s impossible to discount the power of social media. Back in the days of MySpace, social media was a way to connect with friends and family as well as meet new people. Although it still holds these values, social media has become a much bigger part of our collective connectivity.
Today, social media is an alternative to cable television, brick-and-mortar shopping, and job hunting. Social media is where many get their news, find deals, and build their businesses. In many ways, social media is ingrained in just about every aspect of day-to-day life.
That’s a powerful tool.
Founded in 2012, WallStreetBets was designed as a Reddit group that brought retail traders together at a time when there were few resources for those who traded online to connect with each other.
By the beginning of 2021, when the Big Short Squeeze started, the Reddit group had grown to become a community of 2 million members. That sheer size gave WallStreetBets a lot of power in the stock market.
Think about it. An individual investor, even one with $1 million, wouldn’t have the ability to move the needle in most stocks. However, a group of 2 million individual investors with just $100 to invest each would give the group a total value of $200 million, which is plenty of power on Wall Street. Not to mention the fact that the group grew four-fold to more than 8 million members days after the Big Short Squeeze started.
Here’s how it all happened:
1. Hedge Funds Banded Together
For years, hedge funds have been known to band together and wage attacks on publicly traded companies to make a profit. To do so, these hedge funds open massive short positions, meaning they borrowed shares to be sold immediately on the open market. When those shares are sold, the price of the stock falls dramatically as a flood of new share supply hits the market.
When the stock reaches what the hedge funds believe to be the bottom, they band together to buy shares back at lower prices to return, taking as profit the difference between the high price at which they sold and the low price at which they repurchased the shares.
Although short selling was commonplace during the COVID-19 pandemic, this process has been going on for as long as short selling has existed.
2. Retail Investors Lost Money
When hedge funds banded together, retail investors have no idea what’s coming. Investing on the merits of publicly traded companies, many retail investors have lost their shirts when short-selling hedge funds attacked the stocks they invested in.
Many retail investors felt like they were being taken advantage of. They became frustrated with what they believed to be the unfair control hedge funds had on the stock market.
3. Individual Investors Fought Back
Knowing that they couldn’t do much as individual investors, but they could fight back against hedge fund manipulation as a large enough group, WallStreetBets Redditors took to the social network and hashed out a plan.
They would use all their combined investing power to buy shares in the heavily shorted GameStop stock.
Why GameStop? Not only was GameStop stock extremely heavily shorted by hedge funds, it traded with a relatively small supply of shares available to the public, making it easier to tip the scales of supply and demand, forcing prices up.
4. Hedge Funds Backed Off
Once the buying started and with GameStop’s share price moving upward quickly, hedge funds were forced to cut their losses, buying shares to cover their short positions. This led to a frenzy of high-volume buying into a stock with limited shares available to the public.
All the buying continued to push shares up, resulting in more buying and ultimately pushing GameStop to the dramatic gains in multiples that started the Big Short Squeeze.
How Robinhood Took Action
In order to push the short squeezes on GameStop, AMC, Express, and others, WallStreetBets members took to the popular trading platform Robinhood.
Designed for active traders, Robinhood seemed like the perfect fit. The classic story of Robin Hood taking from the rich to give to the poor that formed the basis of the platform’s name made it the perfect place for WallStreetBets users to put their plan into motion.
The problem was that Robinhood had to cover these trades in the clearing house, meaning that Robinhood had to have a fraction of the value of trades in cash before they could clear. With the exceptionally high volume of trades, the company said it couldn’t keep up. As a result, Robinhood announced temporarily restricted trading on every stock involved in the Big Short Squeeze.
Later, allegations arose suggesting that Robinhood may have colluded with some hedge funds to stop the Big Short Squeeze and help some financial institutions that back them. Politico reports that these allegations were being investigated and that the CEO of the company was to testify before a Congressional panel.
Whether Robinhood colluded with any hedge funds is yet to be determined, but if that is indeed the case, there may be serious charges leveled as a result of their actions.
Was What Robinhood Did Legal?
The legality of Robinhood’s actions is up in the air at the moment.
If the online broker restricted trading of stocks involved in the Big Short Squeeze solely because they didn’t have the money to back the trades, there’s nothing wrong with that. There’s no law that says any broker would have to go into debt to serve you. Quite the opposite — there are laws that mandate brokerages keep certain amounts of cash on hand to back up their trades.
There’s also the possibility that Robinhood voluntarily restricted trading in these stocks to protect the small investor. After all, short squeezes are heavily volatile runs, and at some point someone will be left holding the bag and eating serious losses. If Robinhood acted for this reason, then it didn’t do anything wrong from a legal perspective.
On the other hand, if Robinhood colluded with hedge funds to block retail investors from being able to compete with them, then the broker would be in big trouble. Not only would the people involved in the collusion likely face criminal charges, the company would likely be drowned in legal fees and penalties that could jeopardize the entire business.
Regardless of the legal outcome, the publicity from the situation has already been bad for Robinhood, with some frustrated retail investors looking for alternative platforms.
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How Will the Big Short Squeeze Change the Stock Market for Good?
There’s no question that the Securities and Exchange Commission (SEC) and other regulatory agencies around the world took notice of the Big Short Squeeze and watched the volatility that ensued closely. Moving forward, many expect these regulators may make two big moves to protect investors in the future:
- Limits to Leverage. Leverage in the stock market makes it possible to buy multiple shares with a fraction of the upfront principal investment. WallStreetBets Redditors used their cash plus leverage in the Big Short Squeeze to cause such dramatic runs in value. As a result, regulators may crack down on the use of leverage.
- Limit to Hedge Fund Short Selling. In some way, the SEC is going to need to limit hedge funds with regard to shorting stocks. This may come by way of a prior buy rule — where the fund must own the stock in order to be able to short it — or some other rule designed to align the interests of hedge funds with those of individual investors.
There’s also an argument that short selling should be banned completely. Although the act of short selling gives investors a way to profit from a falling stock, many argue the stock market should be about supporting the economy, capitalism broadly, and individual businesses that couldn’t make it without funding from investors. Short selling represents the exact opposite while providing a way to manipulate the stock market and causing painful losses for retail investors.
There are many different views of the Big Short Squeeze. Some view it as a bad thing that shakes up the stock market and turns investing into a gamble, rather than a process based on a series of educated decisions about the underlying value of an investment.
On the other side of the coin, others argue that the WallStreetBets attack on hedge funds has been a long time coming. Not only will the threat of short squeezes make hedge funds think twice about shorting stocks that your grandparents may have sunk their retirement dollars into, it also may lead to regulatory changes designed to protect retail investors from manipulative activities in the stock market.
No matter which side you’re on, one thing is for sure: The Big Short Squeeze will change the stock market as we know it.