Shorts, Options, and Memes: How Redditors Cost Hedge Funds Billions

In some ways, the adventure of GameStop’s stock was more exciting than the games it sells. In January 2021, GameStop (GME) stock rose from $18 to a peak of $483. This meteoric rise wasn’t directly related to anything GameStop did as a company. GME stock was chosen by anonymous users on Reddit to punish billion-dollar hedge funds.

Three things to know:

1. To short a stock is to sell it with the expectation the stock’s price will drop later. That way, the initial seller can buy the stock back at a lower price and profit the difference.
2. This is a great strategy when it works, but there is no limit to how high a stock price can rise. Potential losses are theoretically infinite. Buying stock “on margin” is to buy with borrowed money, supercharging gains and losses.
3. Finally, options allow investors to buy the right to purchase a stock later at a certain price. Investors reap a bigger return if said, “certain price” comes to pass, but they reap total loss if it does not. 

All three factors above came together when hedge funds targeted GME stock. By reversing the trajectory of said stock, Wall Street Bets induced losses of over $6 billion for Melvin Capital. Seeing as the hedge fund manages $12.5 billion in total, this loss is enormous on both absolute and comparative scales. Melvin wasn’t the only group to suffer, either. Short sellers had to sell parts of their portfolios to raise cash, leading to the S&P 500 falling by 2.6%. It was the worst stock market day in three months.

Should regulators do anything about this? While Wall Street is angry, the SEC is only monitoring the current situation. r/WallStreetBets did nothing that was obviously illegal. Discussing which stocks to buy in a public forum is no crime.

Furthermore, prosecuting anonymous users would be an uphill battle for any agency. If anyone is to face consequences, it will be the RobinHood trading app, who attempted to prevent users from buying GME before reversing the decision. They face a class-action suit for this choice.

Photo Credit: NowSourcing