Why /r/WallStreetBets Crazy Ideas Are Affecting Us All
Photo Licensed From Adobe Stock
This isn’t my usual bi-weekly lesson on bubble trading. It’s an important note about the weird impact of Reddit’s /r/WallStreetBets on the broader market and Bitcoin.
My paid subscribers will know by tomorrow morning, for trading purposes, whether the general health of the macroeconomic cycle has deteriorated from green to yellow (I explain the role of the basic economic cycle for bubble trading here).
Here’s an image of what’s going on.
A 2.5% drop isn’t enormous, but the reasons for it have quite broad implications, even for cryptocurrencies. I’ll explain in 3 points.
1. Some Lesser Know Stuff About The Stock Market
So let’s start with the idea of shorting a stock. When someone does this, they borrow the stock that someone owns, through their broker, and sell it on the market. If the stock goes down in price, they buy it back and keep the profit (if it goes up they lose).
- Borrow and sell someone else’s shares of $GRAMF at $12.00.
- Wait for $GRAMF to dip (as almost all post-SPAC stocks do), and buy it back at $10.00
- Return the borrowed shares and keep the difference of $2 a share in profit.
So when you’re shorting, you’re goal is to sell high and buy low (it’s literally the opposite of normal buying and selling).
The Long/Short Hedge Fund
The weird thing about short selling is that after you borrow shares and sell them, you end up with a profit in your account.
Hedge funds use this extra money, while they’re waiting around, to invest in other stuff. They might buy Apple shares or bonds—something relatively safe at least.
That’s what is called a traditional long/short fund. They usually sell 30% of their funds short, and then use that additional money to invest at 130% of their equity, to get greater returns.
That explains why many funds do short selling (though they are on the decline in recent years).
When their short bets go wrong, they aren’t only losing money on those positions, they are going to have to take away from their long positions to pay back those losses (even if their Apple stock was doing just fine, for example).
Bad short bets on one stock, then, can cause the rest of the market to go down because hedge funds have to grab for money from the rest of the market to pay back their debts with the bad short position.
They might even take money away from their cryptocurrency positions if they have those. So, bad short bets could spill over from WallStreet into the CryptoStreet.
2. The WallStreetBets Strategy
The Basic Idea
The basic idea behind /r/WallStreetBets’ strategy is to find companies like GameStop ($GME) that have a large percentage of shares short. There are places to look for this real-time (and you can often do this through your broker). Here’s an image of $GME using just Yahoo Finance.
What is ‘Float’ in Reddit Crypto?
The “Float” is just the total number of shares issued by the company available for trading. The Short % tells you what percent have been shorted. A 260% is absolutely insane. It means that shares have been borrowed and reborrowed more than twice over.
What that means (roughly) is that each dollar stock price goes causes 2.6x the pain for a short seller. Ouch!
That’s why many of them can’t stay in the game for long. But remember, since they are shorting, to close their position they have to buy stock … which pushes the price up even more.
When lots of short positions are covered (closed in that way), it causes a short squeeze. Everyone irrationally sells and the price of the stock soars. That is how you get this:
In the best-case scenario, $GME is worth no more than $40 / share and that’s generous. The price has detached from its intrinsic value (it was at $4 just 6 months ago) because of this short squeeze phenomenon.
The Smart Squeeze
The interesting thing about /r/WallStreetBets is that they are smart. They force these short squeezes with really small sums.
Most Reddit Crypto investors can’t afford more than $1,500 so even if 1,000 of them piled into the stock, it would only make for a $1,500,000 buy …. which is a small hedge fund purchase.
To make their money go further, they take advantage of the stock-market mechanics. Basically, when you put in a buy or sell order through your broker, their computer contacts a market maker to complete the order.
Market makers want to keep their actual position in the market-neutral so that they can continue to facilitate further transactions (they don’t actually want to buy into anything).
When a Redditor buys a call option (a future that allows the buyer the option to acquire the stock at a set price, say $400, by some date, say 2/14/2021) the market maker has to buy the underlying stock to keep their position neutral.
The problem for the market maker is that they will have to spend a lot more money on the stock to neutralize that position—say, $14,000 to offset that $1,500 lot of call purchases.
As more Redditors pile in, the cost of covering for the market maker goes up (in part because now they have to buy the stock at a higher price). They might have to spend $230,000 to cover the new $1,500 in call options. This is called a gamma squeeze (it gets a little technical).
The point of this is that the Redditors, by buying call options are forcing market makers to buy 10x to 30x the number of actual stocks. So, the share price shoots up really fast.
Then the hedge funds that are shorting the stock get squeezed even more, and to cover they have to buy, and the feedback loop continues until what had initially been an $4 stock is trading at over $315 with absolutely no improvement in their business.
3. The Good News
I noted at the beginning that hedge funds, when squeezed this way, are forced to sell all kinds of stuff to cover their positions. Well, what if a whole lot of them do that?
What has happened right now is that all the hedge funds that used the long/short strategy covering their short positions to avoid being mobbed by Redditors. So the whole stock market is declining even though nothing has really changed in the underlying economy.
One bit of good news is for my subscribers. My basic economic cycle algorithm will pick up this kind of shift in hedge funds since a key signal it uses is the dynamics of the futures market (which is the domain of calls options).
Reddit Crypto Bubbles
For those of you who aren’t subscribers, I’ll spend some time explaining how to position yourself to take advantage of Reddit Crypto bubbles. If you happen to know something about option spreads, then I’ll just tell you the answers right now:
- The Safe Way: Covered Calls
- The Interesting Way: Capture Implied Volatility Moves
If you are just interested in cryptocurrencies, then this will only matter if the Reddit situation gets quite severe. Right now, nothing is showing up in the futures market to indicate that fear is coming true.
Reddit Crypto Spilling Over
Independently of the broader market melting down, for example, oil stocks are rebounding nicely and $TLRY and $CGC have continued to take off (which I’ve of course covered here and explain in the subscription).
So there you go: Reddit Crypto is having spill-over effects into the broader market and it’s not going to be easy to stop. It isn’t immediately of concern for cryptocurrencies, cannabis stocks, or the oil rebound, but it is something to watch out for.
I’ll also explain some interesting ways to trade this phenomenon for the next Reddit pump in the coming newsletter.
Notes & Disclosures
General financial disclaimer: I am not providing advice on financial investments and I am not a financial advisor. I am only explaining how I think about this process. Please do your own due diligence before investing in anything.
Links may have referral ids: If they do, and you click on them, and you decide to buy something, the newsletter will receive a small commission that will not affect the cost to you.
Specific disclaimer: At the time of writing, I own a variety of cryptocurrencies, including Bitcoin and Ethereum. I might also own some of the stocks discussed in these essays. In general, I trade these, so by the time you read this, I may not still own them.