How the Reddit retail mob overtook the pros on Wall Street

Wall Street watched GameStop in awe as a group of Reddit-obsessed retail investors managed to climb the stock 1,500% in two weeks, wiping out short hedge funds.

A wave of home traders have landed on the reddit “wallstreetbets” Reddit chat room, whose membership has climbed to over three million. By motivating each other to continue piling up in stocks and call options, they coordinated a monstrous short push at the brick-and-mortar video game retailer.

“Retail investors with the help of technology acting as a syndicate in the attack is a new phenomenon,” said Jim Paulsen, chief investment strategist at Leuthold Group.

“You combine the power of technology, which allows you through Reddit posts to magnify your individual impact, with some use of leverage and highly targeted bets, they can have a significant influence, especially on areas. of vulnerability due to short positions, ”Paulsen told me.

Many enthusiastic Reddit users have posted screenshots of their brokerage accounts, with some boasting astronomical returns north of 1000% in a matter of days. These avid investors often call short sellers in the chat room in colorful language and obnoxious internet memes.

“It’s getting more and more cult,” said Quincy Krosby, chief investment strategist at Prudential Financial. “It’s a bunch of traders and the bunch is growing. The retail crowd isn’t just picking up the shorts and making headlines.”

The intense speculative behavior of retail investors baffles many on Wall Street, as rising losses from hedge funds could spill over into other areas of the market. Some also believe that this buying frenzy could be a worrying sign for a market at record levels.

“This could potentially destabilize the market as a whole and confidence in the market. Those who have not joined will be forced to join,” added Krosby.

These amateur investors have started targeting other heavily courted names including AMC Entertainment and Bed Bath & Beyond, leaving the targets of Wall Street analysts in the dust.

A short seller borrows shares of a stock and sells those borrowed stocks to buyers willing to pay market price. As the stock’s price drops, the trader would buy it back for less, pocketing the difference.

However, when the stock goes up sharply, it forces short sellers to buy back stocks in order to limit their losses. Short hedging tends to fuel the stock rally more.

The rally in GameStop was initially sparked on January 11, when news broke that activist investor and co-founder and former Chewy CEO Ryan Cohen is joining GameStop’s board of directors. The action jumped on the announcement in hopes that Cohen would bring about a change in strategy.

GameStop continued to soar, with retail traders showing no signs of easing off. Amid massive pressure, Melvin Capital closed its short position on GameStop on Tuesday afternoon after suffering a huge loss, the hedge fund manager told CNBC’s Andrew Ross Sorkin. Citron Research short seller Andrew Left said Wednesday he hedged the majority of his short position on GameStop at a loss.

GameStop was the most traded name on the U.S. stock market on Tuesday, overtaking even mega-cap companies like Tesla and Apple, according to Deutsche Bank.

Many passionate Reddit posters promoting GameStop buy call options, a type of derivative contract that gives the holder the right to buy the underlying title at a specified price within a specific time frame. The values ​​of call option contracts can rise even more when the underlying stock rallies 100% per day. Options trading has become accessible and easy for millennial investors, thanks to these new commission-free apps like Robinhood.

“This is all part of the democratization of the market,” Krosby said. “Normally when we talk about leverage and options, it is generally associated with investors, professional managers and hedge funds.”

When retail investors are looking for cheap bull calls, the sellers or market makers who are the intermediaries of the deal run out of many bulls or short gamma calls. As the action goes up towards these strikes, market makers have to buy more and more stocks to cover their short calls. This effectively sped up the rally further into GameStop and other heavily bypassed names.

“The flow of retail orders into options essentially supercharges the short press, like the tail wagging the dog,” said CC Lagator of Options AI. “This gamma effect adds buyer after buyer to the stock, without anyone being able to sell the stock because it is difficult to borrow. The effect is a massive short squeeze.”

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