What a wacky and potentially illegal day we all had today... Brokerages decided the market was no longer a place of free trade and selectively chose stocks to stop trading.
What is a short squeeze?
Why did it make GameStop run like crazy?
Why did this cause hedge funds to panic and lose Billions of Dollars?
-- Here's what happened --
Hedge funds, like Melvin Capital, decided that GameStop (GME) was a dying business that had no chance of regaining their pre-covid market share and would eventually file for bankruptcy.
These Hedge Funds decided to sell Option Contracts within holding the underlying shares, a strategy called "Naked Calls," which means they will provide you with 100 shares at the strike price, on a certain date, per contract they sold. This is similar to the strategy of selling "covered Calls," but in that case you are holding the underlying shares (100 shares per contract you sell), instead of selling "invisible" shares.
Well, WallStreetBets and others recognized this as well. They saw that the Hedge Funds had sold so many Option Contracts that they were agreeing to provide 140% more shares than the company has in total.
-- The Short Squeeze --
WallStreetBets and others banded together and started collecting as many GME shares as possible. When the demand overtook the supply, the stock began to grow, as you would expect. As the stock grew, easily surpassing the Calls the Hedge Funds had sold.
For example, if a Hedge Fund sells naked calls at a $10 strike for $1.00, expiring tomorrow, and the current price per share is $4.50 (Like GME was around August 20, 2020), they are expecting GME to end at under $10 a share, at that point (and they keep your $1.00, remember that is 100 x $1.00 = $100 per contract, times thousands), who would want to buy their shares for $10, when you can buy them on the open market for less?
But what if a bunch of Redditors decided to buy all of those shares before that expiration date? Instead of those shares sitting under $10, they run up to $200... $300... $400 per share, and those hedge funds, who sold "Naked Calls," have to provide them at $10 per share. Those Hedge Funds end up needing hundreds of thousands of shares at whatever the current price is, to fill all of the "Naked Calls" they sold. Now they owe billions, Melvin Capital lost somewhere around $13 Billion, or 30% of their portfolio in this attack.
-- Why this is so significant --
Hedge Funds have been selling naked contracts for years, and it has never been a problem when they take the profits from "retail" investors and add it to their piles. But in this case, the "little guys" banded together to use a completely legal and functional part of the stock market to make profit from a Hedge Fund instead.
At the end of the day, how you invest and what strategy you decide to use is your own. Melvin Capital made a terrible choice selling far too many contracts, and they paid the price for it. Just like any other investment, it was a risk the Hedge Fund took, and they lost.
You don't get to shut down the markets because you lost at your own game. There are already class action lawsuits filed and congress members looking for action to be taken. The ride is definitely not over, and I wouldn't be surprised if we so a lot of volatility as we move forward. People are mad, and mad people usually take action.
This was the same process for other stocks that had heavy amounts of sold contracts, expecting the stocks to remain low. Stocks like AMC, BBW, Nokia, and a few more.
Hope this was helpful and please leave a comment or join the groups! Let's chat about stocks and strategies!
Thank you for Reading,
Kevin Parker
Retail Investor
Dreamer of Financial Independence