In today’s episode, we are going to be discussing the recent euphoria around the GameStop short squeeze, what actually happened and some of the important lessons that new traders can learn from this recent saga!
What Happened with GameStop (Ticker: GME)?
- Around this time last year (2020), GME was trading below the $5 mark and over the course of the year, the price traded as high as $20 in January 2021.
- Then on January 13th and January 14th, 2021, the price doubled to $40 – two days later, it doubled again.
- As a result of this rapid price increase, the media caught wind of this and started running stories on the stock – anywhere you looked, all you saw was “GME” and how retail traders were making life-changing money overnight and beating Wall Street at its own game.
- There was euphoria in the air and everybody and their grandmothers were rushing to open brokerage accounts and pour their savings at GME to catch a piece of the pie.
- On each of the following two days, the stock doubled again, bringing the price to an all-time high of $483.00 over the span of two weeks – this represented a 2,265.33% increase in prices.
- At the time of this recording, GME price was trading around the $65.00 price level – down almost 80% from the Jan 28th highs suggesting that the short squeeze is now over.
How Did the Short Squeeze Happen?
- Late last year, some posters on a subreddit called r/wallstreetbets, started arguing that GameStop actually might be a good buy because the business had a lot of upside relative to the price.
- In addition to this, a number of hedge funds had taken short positions on this stock – so much so, that the short float on GameStop was 120%
- Shorting a stock is simply borrowing shares at higher prices and buying them back at lower prices to make a profit – essentially, these hedge funds were positioned to profit from the price of GameStop falling.
- The Reddit community saw that Wall Street was heavily short this stock and realized that they could potentially orchestrate a massive short squeeze by buying shares of GME together in a coordinated effort, which would drive the price up, and the hedge funds who were short the stock would have to buy those shares back to close their out their position, which would fuel the rally even higher and result in massive losses for the hedge funds.
- What started out as an investment thesis based on fundamentals quickly transformed into a battle against Wall Street that actually gained momentum and mainstream acceptance from the retail crowd – and they were successful in causing some damage to Wall Street – namely Melvin Capital – which had to get bailed out with around $3 billion in order to shore up its finances and ended up covering their position for a massive loss.
Avoiding a Systemic Collapse Using The Silent Exit
- Instead of going out on the open market and buying GME stock to close out their short positions, hedge funds actually went to the Retail ETF (ticker: XRT) to unwind their positions!
- GME represented 20% of the ETF holdings, so while the hedge funds spent more money to buy the other 80% of the stocks, they took delivery of the assets out of the ETF and that’s effectively how they closed out their position in the market.
- Have the hedge funds been squeezed out? The short float of around 20% would suggest yes.
- This short squeeze really had the potential to create a systemic collapse in the financial markets as hedge funds would have had to pay for margin losses by selling large stakes of their positions in big-name stocks like Microsoft, Apple, Amazon, and Facebook to name a few, which would have provided downside pressure to the stock indices.
- Fortunately, it did not get to this point, but in the aftermath, the ones really affected by this were those that joined the party late, bought into the hype near the highs, and held all the way down “hoping” it would come back.
Here are the 5 Important Lessons That We Can Learn From This
Someone always ends up holding the bag
- We can’t all win and somebody always loses
- When you buy shares, the only way to get paid is to sell them at a higher price and somebody has to buy them from you
- When everyone that wants the stock has already bought it, who is going to buy it from them at a higher price if demand fizzles out? Nobody – they become sellers waiting to happen
Holding regardless of developments in the market is a losing strategy overall
- Every stock symbol you could put up will have paid off at some point in its trading history
- Think about the companies that don’t exist anymore (ie. Enron, Nortel Networks)
- All of the companies that are now defunct exceed the total number of stocks available to trade today
- Just buying something and holding it forever without any rational analysis on it on a continuous basis is not a good idea
- In the long run, more companies go bankrupt then they stay afloat
- Looking at the symbols in the market right now is not an accurate way to predict what will happen because you are not looking at the universe of all companies, just the ones that survived.
- Remember it only takes one bankrupt company to wipe out a portfolio when you are getting greedy
Amateur traders chase gains; professionals focus on managing risk
- The biggest focus for amateur traders is to what they will do with all of the profits they imagine that they will make when considering buying a stock seeing momentum
- There is no focus on risk management nor is there any strategy or plan; just trading based on emotions
- Professional traders, on the other hand, concern themselves with entry & exit plans, as well as risk management.
- They have a trading plan before taking on a position; if you don’t have a plan to get out before you get in, then you are getting out based on emotion.
Huge opportunities don’t last a long time
- Whenever a huge deviation of a move happens that exceeds the level of what it should be, it’s a only temporary opportunity.
- This is because there are trillions of dollars at work in the market to make it efficient again – this takes the form of arbitrage
- If you are in a position and the market moves in a way that exceeds what you were looking for when you entered, it’s a good idea not to get greedy but to take profit.
Following other people’s trades is a horrible idea
- The worst thing that you can do to yourself is to lose money on someone else’s idea
- If you wanna do that, you can use a financial advisor
- It’s your money, you work for it, so why invest in someone’s opinion?
- You should learn how to think for yourself and to build confidence in an approach that meshes well with your personality.
- The journey is not easy, but it is well worth it!
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- Catch up with our earlier episodes: Mind Over Markets Podcast