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Reddit’s r / WallStreetBets just cut a hedge fund. You will love what comes next.
As a member of r / WallStreetBets, a popular Reddit forum, let me tell you this: it wasn’t supposed to happen. Our cheerful group of ragged investors were supposed to use our little corner of the internet to trade risky investment ideas, not to destroy one of America’s largest hedge funds. Source: Mehaniq / Shutterstock.com Yet here we are. Over the past week, traders reading the WSB and other forums have been pushing GameStop (NYSE: GME) and a host of other hotly sold stocks to insanely high levels, bankrupting at least one hedge fund and causing the shutdown of several platforms. Wall Street’s response was so clumsy that longtime nemesis Congressmen Ted Cruz and Alexandria Ocasio-Cortez even pulled off a coordinated (Twitter-wagging?) Tongue-in-cheek game on the U.S. financial system. But as Citadel picks up the pieces of Melvin Capital and Reddit users find their next short-term target, people start to wonder, “What’s next?” InvestorPlace – Stock News, Stock Tips & Trading Tips Reddit’s r / WallStreetBets Gives Citron a Taste Let me be clear: you won’t find my posts on r / WallStreetBets. Even though I read and enjoy the platform, my work and my ethics prevent me from talking about the stocks I own. (Sorry, Elon Musk. I wish I had been you.) Wall Street Bets has always been about fun. Many of the posts are intentionally dumb – think out of the ordinary calls to failed retailers – and many contributors show screenshots of lifetime savings going to zero. Profitable or not, it was about finding the joys and absurdities of stock market speculation. In November, GameStop was one of those fun little businesses. And it all seemed like quite a standard fare for the subreddit billed as “4chan finding a Bloomberg terminal”. GameStop fans applauded the buyers while cursing Melvin Capital for selling the stock. All in the hopes of achieving America’s favorite hobby: making a lot of money with as little effort as possible. But then Citron Research changed everything. Lemon research? Meet r / WallStreetBets On January 19, respected short seller Andrew Left finally managed to pick the wrong target. As a longtime outsider on Wall Street, Mr. Left made a name for himself by exposing companies like Valeant Pharmaceuticals, whose executives were channeling and driving up the prices of life-saving drugs. He would have made a big contributor to the WSB, if he had been prepared to put up with the hate speech of 15-year-olds. But then something happened. The day before the presidential inauguration, Mr. Left announced that he would explain why GameStop shares were only worth $ 20. Maybe Mr. Left was right in targeting GameStop, a declining company that gave its executives another $ 20 million. Or he could have been wrong – at $ 20, GameStop was still worth less than half of Best Buy (NYSE: BBY) when adjusted for sales. But it didn’t matter at all. Suddenly GameStop became more than a lucrative business for Redditors. It has become a way to fight the greed of Wall Street; now it was war. How did WSB do it? In a financial system that values a stock based on its last trade price, even small trades at odd prices will re-evaluate a hedge fund’s entire stake. In other words, a few purchases at the right time can cause chaos, especially in stocks with few sellers. This is exactly what happened with GME. Until then, short-term interest had remained relatively stable. Market makers, the backbone of America’s financial system, did their job of matching orders and sales. That all changed on Wednesday when prices went from $ 150 to $ 350. As the market makers started to take hold, the markets started to rampage. This created problems for Robinhood. Robinhood halted trading for GameStop and nearly a dozen other companies on Wednesday. “In order to protect our business and protect our customers,” CEO Vlad Tenev later told CNBC’s Andrew Ross Sorkin, “we had to limit purchases of these stocks.” Can Robinhood go bankrupt? In the world of trading, most conservatively managed platforms don’t have a hard time managing liquidity. As long as you have enough capital and maintain disciplined margin requirements, it’s rare for your clearinghouse to force you to raise new capital. But when it comes to Wall Street, financial companies all seem to run into the same problem: When your customers are making so much money, it’s hard to resist the temptation to join them. Financial regulators have long known about these Wall Street shenanigans. Banks from Bear Stearns to Barings all went bankrupt when they tried to swap clients’ money like theirs, leaving taxpayers and shareholders to foot the bill. Many others experimented with minimum capitalization – only later to realize their disastrous mistakes. So over the years, smart governments have at times found the will to ban such practices and enforce strict margin and capital requirements. (Often those rules would be overruled by even smarter financial lobbyists.) Today, many platforms are using a loophole to lease clients’ securities for profit. And when GME shares can be leased at 25% interest rates to short sellers, there is a great temptation for these financial firms to double down. Did Robinhood do this? Perhaps. Despite Robinhood’s claims that shutting down operations was proactive, the company has always set capital limits and banned users from purchasing more GameStop shares – a signal that Robinhood itself may have run out of capital and actions. (Since Robinhood is privately held, we may never know the truth.) But will Robinhood have regulatory issues? Almost certainly. The company on Wednesday banned trading in a dozen stocks during the peak period of investment demand – apparently because the company needed time to raise new capital. So as retail investors looked aside, hedge funds cashed in at much lower prices. In a very real sense, Robinhood has arguably saved institutions billions of dollars at the expense of investors. Should we be afraid? As Wall Street picks up the remnants of Melvin Capital and the fallout from GME, two things have become clear. 1) “Stupid money” isn’t that stupid after all, and 2) “smart money” is taken to the stake. First, consider what Wall Street has long called “dumb money,” the retail investor. Most of these people are like you and me – investing the majority of savings in stocks for the long term for retirement, while playing with a small portion for fun. And the cheerful absurdity of r / WallStreetBets aside, most retail investors tend to know what they’re buying (even if they sometimes get the valuations wrong.) Robinhood’s Top 100 stocks represent a wide range. consumer-related companies that have grown in real-world popularity as well as equity-related fame. Second, the GME fiasco has exposed “smart money” for the absurd bets they sometimes take. While a long-short hedge fund can help investors smooth out gains, they are often as bad as what they call “dumb money” at closing losses. Melvin Capital, for example, lost 30% of its net worth in the first three weeks of January. But it took another six days (after the stock gained another 250%) for the hedge fund to finally abandon its gigantic position. Since then, other hedge funds have rallied to replace Melvin in this high stakes’ pass the hot potato ‘game, as if to prove r / WallStreetBets’ point that hedge funds will always try to make more money. with regular investors if they believe the odds are good. GameStop also unveiled the revolving door behind hedge funds and market makers. When $ 35 billion fund Ken Griffin’s Citadel LLC bailed out Melvin Capital, Twitter users were quick to point out that Citadel also had a market-building operation that served no one other than Robinhood. Where to go from here? Investors looking to immerse themselves in the financial system would do well to buy index funds and stick with them forever. You might not have the joy of watching a hedge fund explode, but companies like Citadel that rely on retail money will see their earnings dry up. But for those looking to invest wisely, consider this. With the new power of retail investors, you can expect short sellers to think twice before selling a business. Andrew Left of Citron Research has previously pledged never to publish reports on short sellers again. Other hedge funds are watching nervously. This means that hot stocks will move faster than ever. As Reddit users learned this week, it doesn’t take much to influence stock prices when only marginal trading matters. And without someone willing to sell stocks short in the face of an angry crowd, price spikes will become more and more common. You can expect lots of winners and losers. The stock market, after all, is primarily a fixed sum game. But for long-term investors, the same truth still holds: the road to consistent wealth has always been to buy a bunch of high-quality investments bought at a reasonable price. Practice this discipline with your core wallet and you will have great joy in joining me to read about the trials and tribulations of others on r / WallStreetBets. As of the publication date, Tom Yeung does not hold (neither directly nor indirectly) any position in the securities mentioned in this article. Tom Yeung, CFA, is a registered investment advisor whose mission is to bring simplicity to the world of investing. No More InvestorPlace Why Everybody’s Investing in 5G Everybody’s BAD The Best Stock Picker Reveals Their Next 1000% Winner It doesn’t matter if you have $ 500 in savings or $ 5 million. Do this now. Reddit’s r / WallStreetBets post just destroyed a hedge fund. You will love what follows. appeared first on InvestorPlace.
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