Investing: Game stopped
It’s been hard to escape the story of Gamestop, Reddit and a battle of Hedge Funds in the last couple of weeks.
For those of you that haven’t seen it (plus points from me for not reading the financial pages) - a little background.
Reddit is the world’s largest online message board. It has a variety of different forums where users can talk about anything from football to cookery. One such section is the ‘Wall Street Bets’ forum, where users share their own tips and experiences in trading shares.
As trading shares has become much easier due to new phone apps and lower broking costs, these forums have seen a steady rise over the last few years.
A user on this forum noticed something of interest about the shares in US retailer Gamestop. Gamestop is a video games retailer that you’d find in many shopping centres across the states.
As you’d imagine the profits of such a bricks and mortar store had fallen steadily in recent times, as more people switched to online shopping or directly downloading games for their systems. It’s share price had reflected this falling down to single dollar figures.
The user on Reddit had noticed something else though – a significant number of Hedge Funds held short positions against the stock.
What is a Short Position?
A short is basically a bet that a stock will fall. It’s the opposite of traditional investing where you hold a stock in the hope it rises and pays you a dividend over time (also known as a long position).
Hedge Funds are so named because they can hold short and long positions – hedging their bets if you will.
To create a short position, a Hedge Fund must borrow shares from a shareholder in Gamestop. In return for borrowing the shares they pay the original share holder a fee for doing so.
The Hedge Fund immediately sells the shares they’ve borrowed and hopes that when the original owners ask for their return (or they decide to return them), they can buy them back off the market at a reduced cost.
An example:
You own a coat worth $100. I borrow the coat from you and offer to pay you $1 for every month I borrow it for. I immediately sell the coat for $100.
In 6 months time, the coat is on sale at half price. I buy the coat for $50 and return it to you.
I’ve pocketed $50 less the $6 ‘borrowing fee’ for a nice profit of $46.
So what happened?
One Redditor notices that nearly 100% of all GME stock is tied up in short positions. So much so, that if the stock price were to rise, the Hedgefunds would be in a lot of trouble. He begins to buy GME shares and tells the Wall Street Bet’s message board – one by one they begin buying shares and soon hundreds of users are jumping on. The price of GME shares starts to rise.
As early investors start showing screenshots of very healthy balances, other users fearing they will miss out, join in.
What do we know about share prices?
1. There are only a limited number of stocks available to buy in any one company.
2. When demand rises, prices rise (for there must always be a seller willing to sell at the price you’re willing to pay).
Pretty soon, anyone who had lent their shares to a Hedge Fund started asking for them back. The Hedge Funds are having to pay ridiculous money for a stock in a failing company, that has now risen from $18 on the 1st of January to $483 per share on the 27th of January.
Then the switch was flipped: Two of the biggest online brokers in the US – Robin Hood and WeBull both suspended the purchase of GME shares citing ‘extreme volatility’ meaning they had a duty to protect investors - a clause normally only enacted for major catastrophes.
It was a move roundly panned by both sides of the American Congress but it did act as a circuit breaker. Hedge Funds could correct their positions and many traders got cold feet and sold out.
The problem with any move of a herd is that the last ones in are left holding the bag. With more sellers than buyers, the price went down as quickly as it rose.
Those who bought in at over $300 per share sit today with 80% loses – given where the interest started many are likely to be young or inexperienced traders.
What can we learn from the fall out?
Day trading is the exact opposite of what we should strive to do with our family’s money. It’s concentrated on a small number of stocks and short time period and to an extent (when going well) it’s exciting!
Long-term investing is a comparatively boring pursuit involving long period of time where to achieve the best results, we must fight the urge to make changes and do something different to our plan.
Hedge Funds will continue to exist but offer very little value over the long-term strategies we use at Metric Wealth. The recent COVID downturn in the markets should have been the ideal environment for them to show their skills and make money while stock fell. However, they failed to do so.
Short selling continues to be a legal practice but to my mind, making money out of a companies’ misfortune doesn’t sit morally well with me. I’ll continue to avoid funds that do so.
Above all it should remind us that investing isn’t a game – new apps like Robin Hood are like using a pokie machine – confetti cascades down when you make your first trade. The Australian SelfWealth trading app, here in Australia tells you how much your shares have gone up or down in one day as soon as you open it, prompting you to trade. It compares your returns in one day to other investors like a leader board.
Leader boards aren’t important, how far you’ve progressed is.
