By Louis H-P on February 14, 2021Reading Time: 4 minutes
Reddit day trading could be a form of systematic risk. Even a contrarian investor would have been caught off guard by the move in GameStop’s share price. Downside risk is something that every investor expects, but market manipulation is not. The extraordinary events at the start of 2021 have created some new risks for investors to think about.
What did the Reddit day traders do?
Was their activity illegal?
The new and increased risks they have created
In early 2021 some weird and volatile moves in a minority of unimportant stocks started to attract attention. It subsequently transpired that users of the r/WallStreetBets Reddit chat were colluding to buy positions by encouraging each other to bid up the price of GameStop. Although there was stated desire to beat the hedge funds at their own game, reddit day traders started to behave just like a hedge fund manager would!
The stocks they were buying had all the hallmarks of distressed assets. These were not even stocks where profits could be expected soon due to them being caught up in megatrends. This also had the affect of making these unknown stocks into hot stocks, whilst making normal price discovery impossible.
It is clear some hedge funds lost big. Melvin capital had to be bailed out by Citadel to the tune of $2.75 billion! It is also apparent that some Reddit traders would have made substantial profits as GameStop share price went from $17 to $483!
It is not clear how many copy cat Reddit traders lost money though. As millions become interested, some novice traders would have faced the difficult decision of when to sell stocks. Some may have hanged on too long.
Typically hedge funds are the best at measuring risk and ensuring some form of capital protection. Their trades usually involve a margin of safety, so it was a little surprising to read how concentrated they were in GameStop.
To have more shares borrowed than were actually available to be bought was an unacceptable level of risk. Such concentration would have made the position iliquid if everyone did the same thing, which is exactly what happened.
Many of the reddit traders were using some form of leverage. This could have included trading options or futures. This was in the form of credit extended by their broker or options to buy into GameStop. What they did not understand, is that leverage is dangerous and creates problems.
Many Reddit were outraged to find that Robinhood and other online platforms had limited or banned them from trading GameStop and other shares caught up in the frenzy.
What they did not realise, was that the risk to their brokers had simply got too big, too quickly. As the volatility of the shares, and leverage built up placed more demand on the system, i.e. increased the risk, clearing brokers demanded more margin.
The main US clearing houses, run by the Depository Trust & Clearing Corporation had decided the risk was so great, they wanted increased financial guarantees. This forced the platforms to halt trading in these shares until they could get the financing they needed.
Typically regulators are slow to respond to fast moving new situations. In their defence they do not want to act in haste and get it wrong. The collusion displayed by Reddit day traders to buy the shares in the hope of creating a short squeeze, can be described as a form of market manipulation. The insanity in the share price moves of GameStop eventually spilled out into other areas. Defunct companies share prices ended up being pushed up. Eventually the SEC suspended trading in one stock. The accompanying SEC statement makes it clear what it thought: ”…certain social media accounts may be engaged in a coordinated attempt to artificially influence the share price of SpectraScience Inc. (OTC: SCIE)…”.
Markets are based on confidence. If you remove it, you create fear. Although some of the Reddit day traders may become serious investors in the future, many will probably try and repeat their public stock-manipulation-trick again.
During the 2010 flash crash, as stock prices became divorced with reality, professional investors all pulled back from trading. This accentuated that day’s shocking moves. If Reddit day traders repeat their actions again, this could lead to a ‘ fear event’, where everyone panics and sells out/stops trading as they do not trust the prices they are seeing. This will lead to further selling.
Something similar happened in the 1929 crash where the ticker tape could not update fast enough to reveal the latest price. This caused investors to panic further and sell even more. This is something that investors will have to watch out for.
A more day-to-day focus will be on which way the investor wind is blowing. If a stock is being discussed publicly, you will need to be aware of the prevailing wind.
The market can stay irrational longer than you can stay solvent.
Although companies with strong financials will always prevail, if the market is trading one way, it can be difficult to fight the deluge of trades. This leads to a another risk, named the crowded trade.
If something looks wonderful but many other traders have already bought in, you may be better off ‘letting that one go’. If you do not, you could easily end up with a big loss if you lose your ability to exit a trade. There is nothing worse than trying to sell out when everyone else is.
Investors should never forget equity risk. Markets evolve. You have to have the trading mindset to evolve with them. That means what caused a sell off last time, may not be what causes one in future.
You will have to be prepared for Reddit day traders and other-currently-unknown trader groups to create increased volatility and insanity in other asset classes.
Cryptocurrency trading is a prime example. It is driven by retail investors. With momentum investing de rigeur today, you should be more careful than ever of volatility!