The Science of a Short Squeeze: What Happened With WallStreetBets and Robinhood
An explanation of a short squeeze and how it affected retail traders at the peak of the Gamestop squeeze, causing thousands to lose money while companies like Citadel closed positions.
If you follow the news at all, you’re certainly aware of what’s been happening with the stock market.
It’s an engrossing story: through herd investments in heavily-shorted stocks, certain members of a Reddit community called WallStreetBets became overnight millionaires at the expense of wealthy hedge fund managers.
The group’s mass investments skyrocketed the values of stocks like DOGE, AMC, and most prominently GME (Gamestop).
According to an article by Seeking Alpha, between January 12–28, GME stock went from under $20 to $347 a share, a historic increase, which prompted incredible fear from Wall Street investors who had been short selling these stocks.
Fear on their part was justified. For example, Melvin Capital, one of the hedge funds that shorted Gamestop, lost 53% in January. The actions taken by WallStreetBets were a major contributing factor to this drop.
But why did these experienced hedge fund managers fail when retail traders succeeded? What even is short selling anyway?
Short Selling Explained
Put most simply, short selling is betting against the success of a stock/company. While the average investor seeks to buy low/sell high, short-sellers profit off of stocks whose prices they believe will fall.
Short selling begins when an investor “borrows” shares of a stock that they believe will fail. The investor then sells these borrowed shares to buyers willing to buy at market price. When the value of the stock decreases, the investor purchases the same amount of shares that were initially borrowed and returns them, thereby making a profit by selling the stock for a higher amount than what it was later purchased for.
However, in the case that the shorted stock increases in value, there is unlimited potential for loss.
Since the price of GME rose so sharply, shorters were rapidly losing billions, forcing them to short squeeze their shares of GME, and other stocks surged by WallStreetBets.
A short squeeze occurs in response to sharp rises in shorted stocks; it is when traders who bet against a stock must scramble to buy shares in order to prevent further losses. This in turn only further increases the value of the stock that was being shorted.
There is a reason that short selling is only recommended to experienced investors: the risk is extremely high compared to conventional methods of investing. One could argue that hedge funds like Melvin Capital were aware of the risk involved in shorting and that their losses should not limit ordinary people from investing.
However, some brokerage firms seemed to disagree.
The Controversial Response of Brokerages
In response to the surge in the value of what has now been dubbed “meme stocks,” several brokerages, namely Robinhood, WeBull, Voyager, eTrade, and Stash, restricted trading for these securities, including $GME and $AMC.
The decision was understandably met with dissatisfaction, particularly from investors who were planning to buy the now-restricted stocks.
The offending brokerages were accused of manipulating the market, preventing retail traders from reaping the benefits of a free market, as well as allowing already-wealthy hedge fund traders (like Robinhood partner Citadel Securities) to regain some of their profits.
Of all the brokerages who imposed trading limits, Robinhood undoubtedly caught the most heat from both retail traders and the media, oftentimes being the only named perpetrator in articles about the incident.
Retail traders and the media were apparently not the only ones who called the company’s actions into question: Robinhood CEO Vlad Tenev testified before the House Financial Services Committee on February 18.
Vlad’s Defense
Following the controversy, Tenev attempted to defend himself via Clubhouse conversation with Elon Musk, Tesla CEO and public supporter of WallStreetBets. While it’s debatable whether or not Musk “grilled” Tenev to the degree that some would have liked, the conversation was undeniably informative, as the public was finally given a detailed explanation of the situation from Robinhood’s perspective.
After Musk bluntly asked, “Did you sell your clients down the river or did you have no choice?” Tenev provided a lengthy response, ultimately claiming that the decision to restrict trading “was a clearing house decision… It was just based on the capital requirements. So [hedge fund] Citadel and other market makers weren’t involved in that.”
To briefly explain the “capital requirements” that Tenev is referring to:
Stock market settlements are not instantaneous. After a trade occurs, the system allows two days before money and securities must be exchanged. This is called a T+2 Settlement.
Over the course of these two days, there is always a small risk that one party may be unable to complete the trade. This risk is increased when the stock being traded is extremely volatile (i.e. GME). Because of this, a brokerage like Robinhood must offer their clearing house money for collateral, in case a trade falls through.
According to Tenev, Robinhood’s clearing house National Securities Clearing Corporation demanded a whopping $3 billion in collateral to cover the risk of volatile stocks like GME. He asserts that the company had no choice but to restrict investments as they scrambled to raise the money. “We knew this was a bad outcome for customers,” he said. “People get really pissed off if they’re holding stock and they want to sell it and can’t.”
Musk called into question the legitimacy of Tenev’s claim that the NSCC wanted $3 billion, asking, “Why is it so high? This sounds like an unprecedented demand. What formula did they use to calculate that?”
Tenev responded, “$3 billion is a large number and basically the details are — we don’t have the full details — it’s an opaque formula. One is the VaR, value at risk. There are ways to reverse engineer it, but it’s not kind of publicly shared and there’s a special component which is discretionary which acts like a multiplier.”
Musk then asks, “Did something maybe shady go down there?” to which Tenev responds, “I wouldn’t imbue shadiness to it or anything like that,” before reasserting, “I don’t have full context of what was going on in the NSCC to make these calculations.”Robinhood has since lifted trading restrictions on all stocks. How long this will last is hard to say. “I think there’s always going to be some theoretical limit,” Tenev told Musk. “We don’t have infinite capital.”
What the SEC Has to Say
With everything that has taken place, many are now considering the ways in which zero-commission trading can potentially change the market forever. It is a relatively new concept and has understandably led to more ordinary people investing.
The SEC is currently preparing a report on the current trend of market volatility, with U.S. Treasury Secretary Janet Yellen claimed, “We really need to look at whether the trading practices are consistent with investor protection and fair and efficient markets.”
She added, “In a world of very low interest rates, price-earnings type multiples tend to be high… there are maybe sectors where we should be very careful.”
Conclusion
To many, a short squeeze of this magnitude was unheard of. However, this is surprisingly not the first time that an event like this has occurred. In 2008, Porsche instigated the mass purchase of stock in Volkswagen, a Porsche partner and — at the time — a heavily shorted company. The hedge funds shorting Volkswagen lost some $30 billion due to the upsurge in the company’s stock.
What made the WallStreetBets short squeeze revolutionary was the advent of “meme stocks,” as well as the role that social media played in the incident. In the case of Volkswagen, the short squeeze that crippled hedge funds was instigated by a corporation. However, the events of 2021 were led by ordinary people, making for an inspiring story to say the least. In fact, Netflix is already planning a film about the event.
It is understandable that retail traders had a negative reaction to trading restrictions. It seemed that brokerages were betraying the “free market” ideals that they were supposedly founded upon and indicated to many that hedge funds would always find a way to remain on top of the market.
However, in spite of trading restrictions, WallStreetBets remains an active, flourishing community; the entire situation showcases the powerful influence of social media and hints at a future in which retail traders will have more control over the market.
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