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Reddits r / WallStreetBets just got rid of a hedge fund. You will love what comes next.
As a member of r / WallStreetBets, a popular Reddit forum, I want to tell you this: It should never happen. Our lucky group of rag-tag investors should take advantage of our little corner of the internet to exchange risky stock investment ideas, rather than take down one of America’s best known hedge funds. Source: Mehaniq / Shutterstock.com But here we are. Over the past week, traders reading WSB and other forums took GameStop (NYSE: GME) and a host of other severely shortened stocks to insanely high levels, bankrupted at least one hedge fund, and caused multiple platforms to cease trading. Wall Street’s reaction was so persistent that Congressmen Ted Cruz and Alexandria Ocasio-Cortez, long-time sworn enemies, even managed a coordinated wagging of tongues (Twitter wiggle?) In the US financial system. But when Citadel picks up Melvin Capital’s pieces and Reddit users find their next short squeeze target, people start asking, “What’s next?” InvestorPlace – Stock market news, stock advice and trading tips Reddits r / WallStreetBets gives Citron a taste Let me be clear: you won’t find my posts on r / WallStreetBets. As much as I read and enjoy the platform, my work and ethics prevent me from talking about stocks I own. (Sorry Elon Musk. I wish I was you.) Wall Street Bets was always about having fun. A lot of the posts are deliberately stupid – think out-of-the-money calls to failed retailers – and there are plenty of contributors showing screenshots of life savings going to zero. Profitable or not, it was all about finding the joys and absurdities of market speculation. GameStop was one of those fun little ventures back in November. And for the subreddit dubbed “4chan Finding a Bloomberg Terminal,” everything seemed like a standard tariff. GameStop fans cheered the buyers while cursing Melvin Capital for selling the stock short. All in the hope of realizing America’s favorite pastime: making a lot of money with as little effort as possible. But then Citron Research changed everything. Citron Research? Meet r / WallStreetBets On January 19th, respected short seller Andrew Left finally managed to pick the wrong target. As a longtime Wall Street outsider, Mr. Left made his name by exposing companies like Valeant Pharmaceuticals, whose executives poked and skyrocketed the prices of life-saving drugs. He would have made a great contribution to WSB if he had been willing to endure hate speech from 15 year olds. But then something happened. The day before the president’s inauguration, Mr. Left announced he would make an argument as to why GameStop stock was only worth $ 20. Perhaps Mr. Left was right to target GameStop, a shrinking company that is still awarding its executives $ 20 million. Or he could have been wrong – at $ 20, GameStop would still be less than half the Best Buy (NYSE: BBY) when adjusted for sales. But that wasn’t important at all. All of a sudden, GameStop became more than a money maker for Redditors. It became a way of countering Wall Street greed. Now it was war. How did WSB do it? In a financial system that rates a stock based on its last trading price, even tiny, odd-priced trades will reevaluate a hedge fund’s entire holding. In other words, a few timely purchases can wreak havoc, especially for stocks with few sellers. This is exactly what happened to GME. Until then, short interest had remained relatively stable. Market makers, the foundation of the US financial system, did their job matching orders and sales. That changed on Wednesday when prices jumped from $ 150 to $ 350. As the market makers took hold, the markets went wild. That meant problems for Robinhood. On Wednesday, Robinhood ceased trading with GameStop and nearly a dozen other companies. “In order to protect our company and our customers,” CEO Vlad Tenev later told CNBC’s Andrew Ross Sorkin, “we had to limit the purchase of these stocks.” Can Robinhood go under? In the world of trading, most conservatively run platforms have no issues with managing liquidity. As long as you have enough capital and follow disciplined margin requirements, your clearinghouse rarely forces you to raise new capital. But when it comes to Wall Street, all financial firms seem to run into the same problem – when your clients are making that much money, it’s hard to resist the temptation to join them. Financial regulators have long known these gadgets on Wall Street. Banks from Bear Stearns to Barings all went under trying to trade customer money as their own, with taxpayers and shareholders taking the bill. Many more have experimented with minimal capitalization – only later to discover their catastrophic flaws. Over the years, wise governments have occasionally found the willpower to prohibit such practices and impose strict margin and capital requirements. (Often these rules are overturned by even smarter financial lobbyists.) Today, many platforms take advantage of a loophole to lease customer papers at a profit. And when GME stock can be rented to short sellers at 25% interest, these financial firms are tempted to double up. Did Robinhood Do This? Possibly. Despite claims by Robinhood that the trading break was proactive, the company was still pulling back capital lines and banning users from buying more GameStop stock – a signal that Robinhood itself may be short of capital and stock. (Since Robinhood is a private company, we may never know the truth.) But will Robinhood get into regulatory trouble? Pretty sure. The company on Wednesday banned a dozen stocks from trading during peak investment demand – reportedly because the company needed time to raise new capital. As private investors observed from the sidelines, hedge funds were paid out at otherwise lower prices. In a very real sense, Robinhood has arguably saved the institutions billions of dollars at the expense of investors. Should we be afraid? When Wall Street picks up on the remnants of Melvin Capital and the GME fallout, two things became clear. 1) “Stupid Money” isn’t that stupid after all, and 2) “Smart Money” is put in the woodshed. First, let’s look at what Wall Street has long referred to as “dumb money,” the retail investor. Most of these people are like you and me – they invest most of the savings in long-term retirement stocks while playing around with a small serving for fun. Aside from the cheerful absurdity of r / WallStreetBets, most retail investors tend to know what they are buying (even if they sometimes get false reviews). The top 100 Robinhood stocks represent a broad spectrum of consumer-related companies that have grown in real popularity as well as stock-related fame. Second, the GME fiasco has revealed “smart money” for the absurd bets they sometimes take. While a long-short hedge fund can help investors offset gains, they are often as bad at taking out losses as what they call “stupid money”. For example, Melvin Capital lost 30% of its net worth in the first three weeks of January. However, it took another six days (after the stock gained another 250%) for the hedge fund to finally abandon its mammoth position. Since then, other hedge funds have replaced Melvin in this high-stakes game “Pass the Hot Potato” as if trying to prove r / WallStreetBets’ point that hedge funds will always try to make more money with regular investors to be earned if you believe the odds are right. GameStop also revealed the revolving door behind hedge funds and market makers. When Ken Griffin’s Citadel LLC, a $ 35 billion fund bailed out Melvin Capital, Twitter users were quick to point out that Citadel also has a market-making operation that serves nothing but Robinhood. Where to from here Investors looking to get their hands on the financial system should buy index funds and sit on them forever. You may not have the joyous joy of seeing a hedge fund blow up, but retail money companies like Citadel will find revenues drying up. But for those who want to invest wisely, this is something you should consider. With the newfound power of retail investors, you can expect short sellers to think twice about selling a business. Citron Research’s Andrew Left has already vowed never to publish short seller reports again. Other hedge funds are watching nervously. That means hot stocks will move faster than ever. As Reddit users learned this week, it doesn’t take much to sway stock prices if only marginal trading matters. And with no one willing to sell stocks in the face of an angry mob, price spikes are becoming more common. You can expect many winners and losers. After all, the stock market is mostly a fixed sum game. For long-term investors, however, the same truth still holds true: the path to constant wealth has always been to buy a group of high-quality assets at a reasonable price. Practice this discipline with your core portfolio and you will have a lot of fun reading with me about the problems and difficulties of others on r / WallStreetBets. At the time of this writing, Tom Yeung held positions (neither directly nor indirectly) in the securities identified in this article. Tom Yeung, CFA, is a Registered Investment Advisor committed to making the world of investing easier. More From InvestorPlace Why Everyone Is Investing In 5G All FALSE Top Stock Pickers Reveal Their Next 1,000% Winner It doesn’t matter if you have $ 500 or $ 5 million in savings. Do this now. Reddit’s r / WallStreetBets just got rid of a hedge fund. You will love what comes next. first appeared on InvestorPlace.