10 Facts About Reddit Traders (Internet) vs Hedge Funds (Wall Street) You Should Know About

Hedge funds. Short-selling. Market manipulation. Short squeeze. Liquidation. 

A week ago, if you read an article containing the words above, you’d most likely fall asleep, unless you happen to be interested in that sort of thing.

The fact is that most of us don’t know what the heck these words mean, unless we’ve watched The Wolf of Wall Street or The Big Short.

But thanks to a certain subreddit called r/wallstreetbets, many people have suddenly developed an interest in the affairs of the stock market.

Yes, some Redditors who call themselves “degenerates” have taken on the big boys on Wall Street, and it appears that they’re winning.

So, what’s this whole stock market battle about? And why is everyone talking about it?

Here are 10 facts about the modern-day ‘David and Goliath’ story.

To Understand it, You Need to Know What Shorting is

To understand what’s happening, you’ll need to know what shorting is.

Shorting is an investment or trading strategy that speculates on the decline in a stock’s price.

Simply put, you’re betting on certain stock prices to fall in the next few months.

I’ll use an example provided by my colleague to demonstrate how it works.

Today, an S20 Ultra goes for $1,000. But with S21 coming out next month, you know that the price will fall to $800 in six months’ time.

So with dollar signs in your eyes, you head to a retailer and borrow one S20 from them and sell it for $1,000.

Six months down the road, you buy an S20 for $800 and return the unit to the retailer.

The difference between the original and the current selling price – $200 – would be your profit.

Sounds great, right? Well, there are some risks involved.

What if, for some unknown reason, the price of S20 increased to $1,500 instead?

This means that you borrowed and sold an S20 for $1,000, but now you have to spend $1,500 to return the unit, meaning you made a loss of $500.

This is essentially what’s happening on Wall Street, except the figures are a little higher.

It All Started With A Short Squeeze on a Video Game Company

GameStop, an American video game retailer, has seen profits dwindle in recent years due to the emergence of online businesses like Amazon and Netflix; also, people can now download paid games instead of heading to a shop.

The Covid-19 pandemic simply made things worse, as fewer customers visited their stores.

Since GameStop was on the decline, many investors shorted their stocks in the market, expecting the company to go under soon.

But then r/wallstreetbets changed everything. 

A group of Redditors on the forum initiated a short squeeze on GameStop, meaning they generated a rapid increase in the price of a stock by buying and selling GameStop stocks amongst themselves.

So, instead of a profit, the investors who shorted GameStop’s stocks are now facing huge losses, as the price of buying their stock is now higher than the original selling price.

Redditors Have Since Done the Same With Other Companies

If their aim was to make hedge funds lose lots of money, these Redditors certainly succeeded. (But more about that later).

Now, the same subreddit is hoping to replicate the success of GameStop by initiating a short squeeze on other stocks that are highly shorted by professional investors.

And it’s going pretty well so far, according to Business Insider. 

The group has targeted companies like AMC Entertainment, American Airlines, Blackberry, and even Nokia.

Nokia’s shares, for instance, reportedly rose 42% on Thursday (28 Jan), the highest gain since it began trading in 1991.

Hedge Funds are Losing Lots of Money

For the unacquainted, hedge funds are financial partnerships that use pooled funds to earn returns for their investors.

The managers of these hedge funds are the ones who decide what to do with the pooled funds. They employ different strategies to make money, including short selling stocks.

According to Yahoo! Finance, some hedge-fund titans have lost billions due to Redditors messing with their speculative investments.

For instance, Melvin Capital, an investment firm which bet heavily on GameStop’s shares declining, lost 30% of its USD12.5 billion (S$16.64 billion) that it’s managing.

They pulled out of the battle after incurring such a huge loss.

Other hedge funds had to come in and rescue Melvin Capital with a USD2.75 billion (S$3.66 billion) bailout.

One Investor Became a Millionaire – On Paper

The big winners in this battle are those who loaned out their stocks before Redditors entered the fray (as long as the price doesn’t drop again before they return the shares).

We can’t forget the retail investors who bought the shares at a low price, of course.

One auto-parts trader in the US, who makes around $35,000 a year ($46,500), became a millionaire as the stocks he invested in are now worth more than a million.

However, the only way to realise your paper gains on the stock market is to sell them, so until he does, the auto-parts trader will only be a millionaire on paper.

What the Redditors are Doing is Not Considered Illegal

While the hedge funds are crying market manipulation, the Redditors have not actually done anything illegal, as far as we know.

This will be left to the Securities and Exchange Commission — the guys in charge of regulating the market — to decide.

To accuse these Redditors of market manipulation, the commission will have to prove the Reddit traders knowingly spread false information, according to Market Watch.

On Wednesday (27 Jan), the commission said it was working with regulators to “assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants”.

Hedge Funds are Complaining, But Few Feel Sympathy For Them

Hedge funds are crying foul, but few have sympathy for them.

As economist Robert Reich pointed out, the strategy employed by Reddit investors isn’t any worse than that used by hedge funds:

“So let me get this straight: Redditors rallying GameStop is market manipulation, but hedge fund billionaires shorting a stock is just an investment strategy?” he tweeted.

Business magnate Elon Musk also took a shot at these hedge funds, claiming what they do is essentially a “scam”.

u can’t sell houses u don’t own
u can’t sell cars u don’t own
but
u *can* sell stock u don’t own!?
this is bs – shorting is a scam
legal only for vestigial reasons

— Elon Musk (@elonmusk) January 28, 2021

Robinhood, a Trading App, is Restricting Trading in Some of these Stocks

For those who don’t know, Robinhood is a trading app for regular investors. It’s rather popular because it allows commission-free trading.

After the trading frenzy instigated by Redditors, Robinhood announced on Thursday that the company was restricting trading on a number of stocks, including GameStop.

It later explained that it restricted trade not to stop people from buying these stocks, but because of the volatility of those stocks.

This volatility forced the company to come up with 10 times the deposit requirements it had a week earlier in order to execute those trades, according to Vox.

Some Users are Suing Robinhood For Blocking their Investments

In response, some users have launched a class-action suit against the company, saying it manipulated the market by restricting trades, which caused users to lose money.

However, what these users may not know, is that Robinhood is protected from such a lawsuit because of their user agreement.

The user agreement on Robinhood’s website says it “may at any time, in its sole discretion and without prior notice to Me, prohibit or restrict My ability to trade securities.”

And this is exactly what the trading app did.

This Crazy Trading Might Continue For Some Time

While no one knows how long this retail trading frenzy will continue, it won’t be anytime soon.

According to Forbes, a solution for this large-scale market disruption will take time, meaning this crazy trading might continue for some time.

Yes, Redditors appear to have won the battle against these hedge funds, but it remains to be seen who the winners of the war will be.

Featured Image: Jonathan Weiss / Shutterstock.com