How Individual Investors Threatened Multi-Billion Dollar Hedge Funds
Just less than two weeks ago, one stock surged from around twenty dollars to a record four hundred dollars at its peak, only to come crashing back down all within the time frame of two weeks. The cause: Individual investors pumping the stock in an effort to threaten Hedge Funds’ short puts on it. This article is a full explanation of both sides of the Gamestop stock (GME) pump.
For the rest of the article, Gamestop will be referred to as GME (its official ticker on the NYSE).
To give context to the rest of the story, you must know what hedge funds are and how stocks are “shorted.”
What are Hedge Funds?
Hedge Funds are a relatively new system very similar to mutual funds. While mutual funds can be invested in by normal people, hedge funds are invested in by professional, well-known investors. They are an aggregate of investors led by one person or group that make investments for the profit of all investors in the hedge fund. Where hedge funds differ is in their strategies. Mutual funds usually consist of very safe and long-term investments that essentially guarantee money with minimal risk. As Investopedia puts it, Hedge funds are “generally considered to be more aggressive, risky, and exclusive than mutual funds.” The particular hedge funds involved in the GME stock rocket are Melvin Capital, Citadel, and Point 72. In short, Hedge funds are mutual funds for well-known investors that make riskier investments for greater profit.
So what did the Hedge Funds do to lose so much money and get dragged into the public eye? They shorted GME.
What Does it Mean to Short a Stock?
Shorting a stock, or going short on a stock, is the opposite of going long on a stock. Going long on a stock means that an investor buys stock in hopes that it will rise and they can make money off of it. Shorting a stock means that the investor borrows stock from their broker and sells it, hoping to buy it back at a lower price in order to give back to their broker. Essentially, going long on a stock is profiting off of the stock’s success, while going short on a stock is profiting off of the stock’s failure.
What did the Hedge Funds do?
The hedge fund Melvin Capital, along with investments from hedge funds Citadel and Point72, decided to short the stock for the company Gamestop (ticker GME). Traditionally, hedge funds have made safer plays with less money, but the increasing popularity and use of hedge funds caused them to make riskier investments. Citadel and Point72 invested a combined $2.75 billion into Melvin Capital for the shorting of GME.
Why didn’t the GME stock fall and go bankrupt?
At this point in time, Melvin Capital's investment, while risky, was not too different from what hedge funds have been doing for years. This time, however, they experienced retaliation from individual investors. These individual investors first heard about the GME short from social media website Reddit on the popular subreddit r/wallstreetbets (r/WSB).
What is r/wallstreetbets?
r/WSB is a subreddit on the social media platform Reddit with the description “Like 4chan found a bloomberg terminal.” Essentially, the subreddit consists of Reddit users making outrageous bets on stocks in hope that they will someday “strike gold” and become rich. Before the GME short, people would be seen posting about a new stock, the huge gains they made, or the huge losses they suffered. During the GME rally, users would make memes and parodies of popular movie clips showing them facing off against the hedge funds, urging people to buy and hold more GME stocks, and reassuring themselves that by holding the stock through dips and peaks, they have “Diamond Hands.'' Users of the subreddit admit that what they are doing is essentially gambling, and they frequently joke about their stupidity, comparing themselves to apes. The subreddit is entertainment mixed with stock trading.
So… What Happened?
One user on r/WSB, u/DeepFuckingValue, made the subreddit aware of GME stock through his frequent “GME YOLO updates” in which he shows images of the investment of all his money into GME stock from as early as one year before the whole GME short event. His frequent posts caught the attention of other users of the subreddit, and when the hedge funds started to short, these users bought GME stock. These individual investors spent all the money they could on GME and continued to buy it, sending the price shooting up. Fortunes were being made and u/DeepFuckingValue went from having a portfolio worth around $22,000 in January 2020 to a staggering $43 million in January 2021. People who invested in GME while it was still in the double digits also made huge profits, but oddly, the users of r/WSB were not selling. They wanted to make a statement. In their eyes, they were getting back at the hedge funds for taking a risk and for their usual scummy behavior. To the average person, this is true. Hedge funds have become a way for rich investors to easily increase their wealth with little risk and have much higher gains than through regular mutual funds.
This is where the popular trading platform Robinhood comes into the picture. Robinhood is a trading application like Fidelity, Schwab, and other reading platforms, but it is marketed as a platform “for the people.” It is easy to make an account and invest, as many people already have. Many individual investors used Robinhood to buy GME stocks, which later turned out to be their demise.
Robinhood is owned by Citadel, one of the hedge funds suffering major losses because of the GME stock surge. At the height of the GME buying frenzy, Robinhood closed the buying of GME stock, handicapping the ability of individual investors to buy the stock and increase the price. Many people think that the closing off of buying GME stock by Robinhood was monetarily motivated by their parent company, making it a crime.
As to how the whole event ended, no one really knows. After Robinhood closed GME to buying, the stock lost its trading momentum and started to slip. The official statement from Melvin Capital is that they closed all their positions on January 26 at “a significant loss.”
From an all-time low of around $2 in the summer to an all-time high of $483 this January, the remarkable Gamestop stock rally has shown the world the power of individual investors and the corruption of hedge funds. From this event, hedge funds Melvin Capital, Citadel, and Point72 suffered significant losses on a risky play while many small investors and everyday people made it big. A moderately large subreddit called r/wallstreetbets challenged the hedge funds and came out on top. Corruption within the hedge funds and trading platform Robinhood was also seen as the app blocked users from buying GME stock during the peak of its rally, supposedly for monetary reasons, while other trading platforms had not blocked the buying of GME stock. So far, 2021 seems to be a very exciting and eventful year, as shown by the Capitol riots and this stock market surge.