After last week, the market is wondering what the heck just happened.
Stocks that really had no business rallying got as high as Willie Nelson on a tour bus.
GameStop (NYSE: GME), Nokia (NYSE: NOK), BlackBerry (NYSE: BB), AMC Entertainment Holdings (NYSE: AMC) and many others were manipulated higher by retail traders, kicking the hedge funds that were short the stocks right in the… well, right in the shorts.
Here’s how it happened – and, more importantly, what it all means.
Traders on a message board site called Reddit essentially banded together to buy certain stocks that were heavily shorted, like GameStop.
When a stock is sold short, the investor who shorted it is betting it will go lower. They do this by borrowing a stock they don’t own, selling it and then buying it back in the future (hopefully at a lower price) to replace the borrowed shares.
While most investors try to buy low and sell high, short sellers attempt to sell high and then buy low later on.
Now, the Reddit (and other) traders weren’t buying just stocks… they were buying call options too. Each call option controls 100 shares.
When a call option is bought, the market maker who sold it to the trader typically needs to buy shares of stock to hedge. If they don’t, the market maker is short a call, which means they may have to deliver 100 shares for each call if the stock goes higher.
If they don’t own the stock already, they may have to pay a much higher price for it and suffer a steep loss. So they buy the stock at the time they sell the call to hedge their position.
Market makers typically don’t want to be long or short. They just want to make a little bit of money from each transaction.
When the market makers hedge their position, it creates increased demand for the stock. When there are a lot of shares and calls being bought, it creates a lot more demand for the stock.
Here’s the kicker…
Because the stocks were heavily shorted, as they rose in price, the hedge funds that were short were losing money. A lot of it.
When short sellers can’t take any more pain, they cover their short positions by purchasing stock. That creates even more demand for the shares and is known as a “short squeeze.”
By targeting these very heavily shorted stocks, the Reddit traders created a short squeeze and cost the hedge funds billions of dollars in losses.
Now, you may be thinking, so what? Score one for the little guy and too bad for the Wall Street fat cats who have screwed individual investors for years.
You may be justified in thinking that. But it’s not that simple…
After suffering deep losses, these hedge funds may be forced to sell other stocks to raise capital. That’s affectionately known in the industry as “puking” them up.
If enough big funds “puke” up their stocks, that could cause those stocks – and maybe the entire market – to fall. Perhaps sharply.
More significantly, with their newfound power, these traders may decide to push stocks lower rather than higher next time. It shouldn’t be too difficult to do. If they bought lots of puts, that would force the market makers to sell stock in order to be hedged.
That could make the stock decline, forcing other investors to dump their shares, moving the stock even lower.
Lastly, any coordinated effort to manipulate a stock is illegal. You may be happy that the hedge fund guys got their comeuppance, but you should not be happy that it didn’t happen because of free market forces.
The Securities and Exchange Commission is looking into whether or not individual stocks were manipulated. If they were, there could be significant penalties for those involved.
Lastly, as I told readers of my Technical Pattern Profits VIP Trading Service on Friday, I’ve seen this movie before. I know how it ends.
I had a front-row seat to the dot-com boom and bust. The same exact thing happened. Relatively new traders confused a bull market with their own trading “skills.”
The exact circumstances have changed, but human emotion stays the same over centuries. This won’t end well for the majority of these traders. Don’t buy into all of this nonsense.
If you own any of these stocks that have soared as a result of the Reddit push higher, I strongly advise you grab some gains now. Don’t be greedy thinking your stock is going up another 100%. You were handed a winning lottery ticket – cash it in.
If you don’t own them but are tempted to get in the game, don’t. The last thing you want to do is put your hard-earned money into an investment that is being manipulated.
Currently, the news is full of stories of guys making $35,000 a year who are now millionaires thanks to their holdings in GameStop. In a very short time, the stories will be of people who were millionaires on paper and lost everything.
Don’t be one of them.