The Empire strikes back against nerd investors and stock prices surge!

Professional investors such as hedge fund managers and short sellers were taken to the cleaners by amateur retail investors this week, in much the same way as Robin Hood lifted bags of gold from the friends of Prince John and the Sheriff of Nottingham.

But the big rich guys got even overnight! More on that in a minute.

Yesterday, short sellers were caught in a short-squeeze trap,r as a tribe of smart retail investors used their association with the forum website Reddit to gang up on some US short sellers, who needed the share price of a target company to fall not rise. And that’s what the Reddit clan did — they bonded together via their forum on Reddit to push up share prices of a couple of companies!

In case you need a lesson on short selling, think about this: A short seller borrows shares of a stock and sells these borrowed shares to buyers willing to pay the market price. As the stock price falls, the trader would buy it back for less money, pocketing the difference. However, when the stock jumps sharply higher, it forces short sellers to buy back shares in order to limit their losses. The short covering tends to fuel the stock’s rally further.

On Wednesday on Wall Street, a company called GameStop (GME) spiked 134% to $347, while another stock called AMC put on 301% to $14.94, thanks to the Reddit share buyers!

This is how CNBC’s Yun Li explained what happened: “A wave of at-home traders found each other on the red-hot “wallstreetbets” Reddit chat room, whose members have ballooned to over 3 million. By motivating each other to keep piling into shares and call options, they coordinated a monstrous short squeeze in the brick-and-mortar video game retailer — [GME].”

The action of these so-called amateur traders, who look powerfully professional, has meant the pro hedge fund managers have racked up losses that could destabilize the stock market, if these emboldened new age traders target more and more companies.

“The intense speculative behavior among retail investors is unnerving many on Wall Street as mounting losses by hedge funds could spill over to other areas of the market,” Yun Li pointed out. “Some also believe this buying frenzy could be an ominous sign for a market at record highs.”

My colleague Paul Rickard, who was the founding CEO of CommSec, says the Yanks have much easier access to call options that make it easier for at-home share traders to get a piece of the action.

Let me explain what calls options are.

Call options are financial contracts that give the option buyer the right (but not the obligation) to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. A call buyer profits when the underlying asset increases in price.

So these Reddit traders look like they’ve worked out how to rig the stock market to pocket some real profits. But this democratisation of the stock market, where the little guys can ‘stick it’ to the big guys, could create problems that the stock world would never have contemplated.

This world has been changing for some time. In the US, a huge game-changer was the arrival of the free trading platform — Robinhood Markets. Robinhood Markets is a discount brokerage that offers commission-free trading through its website and mobile app. It gets paid by third parties for generating a big flow of orders, coming from lumping together millions of small free trades of small investors.

The CEO and co-founder of Robinhood is Vlad Tenev. In a piece for CNBC, Tenev compared becoming an investor in the US to becoming a home owner in the old days when properties were more affordable.

“I was born behind the Iron Curtain,” he said. “For people in my native Bulgaria, managing money was a simple proposition with just two options — keeping savings in the state bank or stashing it under a mattress.”

Tenev’s family made it to the US after the Wall fell in Berlin and he saw the potential of the stock market as a wealth-building machine.

Powered by the fact that 10% of US households held 87% of all stocks and less than half of households were in stocks, he came up with this idea of Robinhood to “level the playing field”.

The existence of Robinhood obviously increased the interest in stocks for many one-time non-players. But the Coronavirus and more time at home, coupled with a spectacular fall in the stock market and then an astounding rebound, that encouraged many newcomers to stocks to seize the day to build up wealth and/or deposits for that old American dream — a home.

On a smaller scale, newcomers to the share market have piled into beaten up stocks here too. Some months ago, a well-known fund manager was frustrated that he had to compete with these new traders/investors who, he argued, were pushing some stocks to silly levels.

If you need an example, simply think Afterpay, which is a stock so in line with the life of young investors in particular. This chart shows how this company has built up a following and a share price spike that seems excessive, given its current achievements.


Afterpay (APT)


This year, the stock has been as low as $8.01 and as high as $151.22. It fell on Thursday to $136.97, possibly as new, savvy, young, day traders sold out so they could bank profits, as Wall Street stressed out about this routing of short sellers by the ‘Redditteers’.

Their worrying actions caused ‘big end of town’ investors to sell off on Wall Street and it affected our market, which lost nearly 2% yesterday.

Tenev likes to talk for the new age investor. “I’d argue that those who question the capability of retail investors do not have the interests of everyday Americans at heart,” he argues. “It’s wrong to view the arrival of increasing numbers of retail investors in the market with dismay. It’s short-sighted to proclaim that financial instruments integral to investment strategies of the wealthiest Americans should be left exclusively in the hands of the old guard.”

His business has 13 million customers with an average age of 31. He sees them being in the “early stages of building wealth for the long-term, hopefully leading to financial independence and security for them and their families.”

He says his efforts are helping democratize finance and it has so far, but this first-test crash was an unusual one where the rebound was faster than usual crashes. Governments created the recession and the magnitude of the crash by closing economies down, but they then helped the recovery by throwing huge sums of money at the economic problem caused by the Coronavirus.

The GFC crash went from November 2007 to March 2009 and a market collapse like that might be a real test for newcomers to the market.

Tenev likes to compare investing in stocks to buying a home but the value of a home doesn’t jump around the way a share can. Sometimes a homeowner has been made poorer by house price falls but he/she mightn’t know it because real estate price movements have less daily coverage. It also matters little if someone’s house is worth less if they have no intention of moving, though it can affect their willingness to spend.

The new age where young people play the stock market to build their wealth is an example of democratization of finance, but when the next crash comes, the likely clamour for the exit doors via fast-moving computers and online websites, could be more akin to the anarchy we see where crowds tear down palace gates, burn cars and get really mad.

Right now, democracy for stock markets is punishing the old guard bullyboys (hedge fund managers and short sellers), but what lies ahead for all other share market investors is uncertain because we’re in unchartered waters.

On Thursday, I revealed how short seller Michael Burry (the movie The Big Short is based on Burry) recently tweeted that trading in GameStop is “unnatural, insane, and dangerous” and there should be “legal and regulatory repercussions.”

Burry, who’s the founder and boss of Scion Asset Management, made $750 million in profits for his investors and $100 million personally when his bet against subprime mortgages paid off in 2007 and 2008, around the time of the GFC.

Burry is old guard looking for regulations. This is ironic as many long only, buy and hold investors have wanted regulations for sneaky short sellers, who put out questionable research to drive share prices down to make big profits.

Before overnight trading on Wall Street, I wrote: “How the regulators react to this democratization of their stock markets will be interesting stuff in coming days and weeks.”

Well, the ‘Empire has struck back’! We’ve now seen ‘no cost’ brokers such as Robinhood and Interactive Brokers putting restrictions on trading in stocks such as GameStop and AMC, which has resulted in an outcry from their customers, who are out there killing short sellers!

A statement from Robinhood said: “We continuously monitor the markets and make changes where necessary. In light of recent volatility, we are restricting transactions for certain securities to position closing only, including $AAL, $AMC, $BB, $BBBY, $CTRM, $EXPR, $GME, $KOSS, $NAKD, $NOK, $SNDL, $TR and $TRVG. We also raised margin requirements for certain securities.”

These guys could face legal action because of these changes. And the Reddit group of traders are threatening to boycott the business, which could savage the company’s value.

Why did they change the rules of engagement? I’d say pressure from regulators, hedge fund heavies and the companies that actually pay the likes of Robinhood to do their work for ‘free’.

Either way, the ability for investors to collude to buy or sell will be something regulators will have to address. And they should also address sneaky short sellers who falsify reality to send stock prices plummeting. Not surprisingly, Wall Street went up overnight. And our market will go up today too.


Source: Peter Switzer