On Thursday evening Thomas Peterffy, the billionaire founder of Interactive Brokers, took stock of a day unlike any in his over fifty-year trading career. An army of novice traders had united on social media site Reddit and relentlessly bought stock and options in ailing video game retailer GameStop on trading applications such as Robinhood, driving its stock from $20 at the start of the year to nearly $500 that afternoon.
The surge cost Wall Street investors almost $20 billion in mark-to-market losses, and Peterffy’s brokerage spent the day issuing thousands of margin calls on its customers’ bearish GameStop bets, forcing them to realize losses. During the trading day, Interactive Brokers, Robinhood and other online brokerages also restricted some trading in GameStop, movie theater chain AMC Entertainment, BlackBerry and other stocks that were part of the pump. The move, they later said, was to conserve cash as their clearinghouses demanded money to cover potential customer losses amid the fervent speculation.
At Interactive Brokers, Peterffy estimated between $500 million and $1 billion in potential customer losses. Cash also got tight at Robinhood, the Silicon Valley unicorn that had raised billions in venture capital and unleashed the speculative frenzy, introducing millions of young traders to frictionless stock and options trading. It drew down hundreds of millions in its credit lines and raised $1 billion in new emergency cash as its clearinghouse reserves rose tenfold.
Peterffy went to bed that night worried of a market collapse. “If the broker has to pay more money to the clearinghouse for customer losses than he has, then the broker is bankrupt. And when one broker goes bankrupt, usually a few others do too,” he told Forbes late on Thursday evening. “So, I’m worried about a systemic failure.”
The episode of millennial and zoomer-aged Reddit traders taking on Wall Street’s wealthiest and winning has turned into the David versus Goliath tale of the age of inequality. There are some big winners from GameStop, young investors who’ve already taken massive profits that can be used to pay off student debt, or build savings. For many onlookers, the humiliation of Wall Street is icing on the cake.
Despite the wry cheers, GameStop’s surge is surfacing a market fraught with leverage, unprecedented speculation and superficial analysis at almost every corner, exposing enormous risks. The pain started with the hedge funds that lost big, but as risk bubbles over, it will have reverberations in the broader market.
“What’s been happening really is a reflection of the quality of analysis, the quality of work, the quality of input that is coming to Wall Street,” says billionaire investing legend Michael Steinhardt. “And it’s a sorry tale, that something like this can happen and it’s obviously something that will have a bad ending for people who are in a position to afford it least.”
Long-short equity hedge funds generated big gains in 2020 as they bet on the digital companies that thrived during the Coronavirus pandemic, and hedged risks by betting against troubled retailers like GameStop. But they entered the new year complacent.
“When I looked at these shorts, I thought who the heck would be short movie theaters, bricks and mortar retailers and airlines when we’re just beginning to clear bottlenecks in vaccine distribution,” says Barry Knapp, managing partner of Ironsides Macroeconomics. GameStop entered 2021 as one of the most shorted companies in the world, though obvious positive changes were afoot inside the company as online sales surged and customers lined up outside its stores to buy new PlayStation consoles. Moreover, the Federal Reserve has been flooding the market with liquidity and a second round of stimulus checks hit bank accounts at the end of the year, a risk hedge funds should have sidestepped. The complacency was exploited by the Reddit army, to devastating effect.
A hedge fund named Melvin Capital, backed by Billionaire Steven A. Cohen of Point72, was the biggest victim, dropping 53% in January according to the Wall Street Journal, in part due to its GameStop short. One of Melvin’s mistakes was disclosing a put position against GameStop (a bet shares would fall) on its public filings, which gave the Redditors a target to rally around. It could have done the trades over-the-counter, remaining discreet, or closed them. Last week, Melvin required a $2.75 billion infusion from Cohen’s Point72 Asset Management and Citadel, owned by billionaire Ken Griffin, due to its losses.
Other big funds were hit hard. “People are telling me that the pain is anywhere from down 10% on the low end, which is Steve Cohen, to down 30% on the high-end,” says hedge fund insider Anthony Scaramucci of Skybridge. Large funds swept up in the losses include Cohen’s Point72 and highly-regarded funds like D1 Capital, headed by Dan Sundheim, Holocene Capital, Viking Global and Ken Griffin’s Citadel.
These funds may have mistakenly taken a piping hot stock market as a sign of genius, pressing their trade too far. “Tech stocks today are historically overvalued. On many metrics, they’re higher than they were at the peak of the dot-com bubble,” says Kevin Smith, chief investment officer of $200 million in assets Crescat Capital.
Fueling soaring valuations is perhaps the biggest speculative frenzy witnessed in a century, thanks to frictionless and zero-cost stock and options trading by Robinhood. Single stock call option trading has hit new records. Junky GameStop, not Apple or Microsoft, was by far the most traded company in America at times last week. Daily option premiums traded in the video game retailer surged to nearly $10 billion, more than the entire S&P 500 Index.
It’s all thanks to online brokerage Robinhood, which introduced millions of young traders to these dangerous derivative financial products and adeptly built a platform that encourages video game-like speculation. While Robinhood purports to democratize investing, behind the scenes it makes money feeding customers order to Wall Street’s savviest traders (see story). Giant market making firms like Citadel Securities and Virtu Financial have been more than happy to pay for the flow of orders coming from Robinhood, earning record revenues executing the trades in 2020. Time and again, however, the construct has proven unable to handle the rampant speculation it encourages.
For the past year, Robinhood has crashed at the apex of market activity and a new problem emerged Thursday. Because Robinhood onboards clients with margin accounts so they can begin trading instantaneously, it’s required to post collateral for its traders’ activity. On Thursday, the activity was so large, concentrated and speculative, Robinhood’s clearinghouses demanded extra collateral, creating a cash crunch that led to the trading freeze. Robinhood then went running to its venture capital backers for a $1 billion cash infusion.
Lawmakers and celebrities came to the Redditors defense. When trading was restricted in GameStop, just as they could smell hedge fund blood in the water, both New York Congressman Alexandria Ocasio-Cortez and Texas Senator Ted Cruz demanded investigations. Comedian Jon Stewart lamented, “this is bull**it. The Redditors aren’t cheating, they’re joining a party Wall Street insiders have been enjoying for years…maybe sue them for copyright infringement instead!!”
GameStop’s rise began with reasonable analysis, but morphed into an arbitrage that exploits free options trading. Ultimately, it has revealed a new force in financial markets that’s crashing Wall Street’s clubby party, with hard to predict consequences. “Frictionless and highly gamified environments ignite the basest instincts of human nature,” says Paul Rowady of Alphacution Research. “Lubricating people to forego whatever discipline and self-control that they might otherwise have is the intended goal of these environments. And, with sustained exposure comes indelible impacts.”
GameStop’s ascent started in the summer of 2019 when Michael Burry, the hedge fund manager lionized for spotting the housing bubble in “The Big Short,” uncovered his next great trade in GameStop. Burry bought two million shares and recommended an obvious arbitrage. “GameStop could pull off perhaps the most consequential and shareholder-friendly buyback in stock market history with elegance and stealth,” Burry told the company after disclosing his position. “Mr. Market is putting this one right in your hands,” said Burry. Within months GameStop spent $200 million to retire 38% of its heavily shorted stock.
It seeped into social media. In September 2019, Keith Gill, a 34-year financial advisor in Massachusetts, got into the GameStop trade, paying $53,566.04 to buy 1,000 call options on the company and posting his position to Reddit on Sept. 8, 2019 under the pseudonym u/DeepF__ingValue, which eventually became a sensation with millions of followers. By July 2020, he was publishing videos to YouTube under the pseudonym Roaring Kitty, presenting in kitten-themed tee shirts his detailed analysis on why GameStop could gain big if the market grew more optimistic on its sales as a new PlayStation console was released. Others jumped in. Ryan Cohen, the billionaire founder of online pet food seller Chewy, bought 10% of GameStop, and joined its board in the fall, hoping to bolster its digital platform.
With positive change afoot, Reddit posters uncovered the potential for a squeeze due to GameStop’s heavy short interest and the interplay of options trades on platforms like Robinhood and their execution by market makers like Citadel Securities. Because call options are the right to buy 100 shares of stock at a specified price for a specified period of time, the market maker executing the trade (Citadel Securities, for example) hedges itself by buying actual shares. If enough buying activity could be organized, the Redditors realized, demand for GameStop shares would far exceed available supply, pushing prices far higher. Eventually, hedge funds short GameStop would be forced to close or cover their positions and buy GameStop shares at higher prices, adding even more upward pressure to the stock. Those dynamics pushed GameStop up almost 2,000% in 2020, to a $22 billion market value. Had GameStop trading not been halted, it might have ripped far higher, and it may yet.
“It’s not like everyone is an idiot just playing with their money,” says Taylor Hamilton, 23, an IT worker who has made well over $100,000 in profits and paid his off student loans since starting to trade options on online brokerages like Robinhood in March 2020. “We understood what was going on and we understood how to take advantage of the moment.”
The key for the Reddit army is to get out before the music inevitably stops. “We’re in a naturally occuring Ponzi,” says Ben Inker, head of asset allocation at GMO, “The market needs to draw in more and more money to keep this afloat. Eventually you don’t have enough and it collapses.”
For some, the squeeze is the outcome of a decade of encouragement of risk taking. Signs of excess are everywhere, from record Spac issuance to red hot initial public offerings that double or triple in a matter of days. “Policymakers are essentially telling us as investors that the prudent and responsible thing to do in this cycle is to be irresponsible and imprudent. These guys on Reddit figured it out,” says Marko Papic, chief strategist at Clocktower Group.
Things may yet get crazier, and the possibility of a debacle that hits the portfolios of index fund investors seems inevitable. As GameStop and other “meme” stocks squeezed higher, hedge funds liquidated their portfolios en masse, causing a sharp weekly drop in the S&P 500 Index. With hedge funds squeezed to the hilt, brokerages low on cash, and millions of investors maintaining enormously speculative positions, risks of bad surprises abound.
“Where there’s leverage, there’s susceptibility to squeezes and tails,” says Mark Spitznagel, the head of Universa Investments. “The entire marketplace is leveraged in an unprecedented way right now.”
The biggest immediate issue is that the squeeze is far from over. “I keep hearing that most of the GameStop shorts have been covered. Totally untrue,” says Ihor Dusaniwsky, of market data firm S3 Partners. “Brokers have been telling me as soon as some shorts are covering there is a line of new short sellers looking to short GameStop at these high stock price levels in anticipation of a pullback.”
Short interest in GameStop is now $11.20 billion with 57.83 million shares shorted, or 113% of its tradable shares, near record highs, according to Dusaniwsky. Shares shorted have declined by just 8%, despite the billions already lost.
“These stocks could be pushed further,” worries Peterffy of Interactive Brokers, “It is a very dangerous, but very attractive game for both sides and the positions may increase accordingly… SCARY.”
—With reporting from Eliza Haverstock, Halah Touryalai, Christopher Helman, Sergei Klebnikov, Matt Schifrin and Jon Ponciano