Editor’s note: This article was first published in February 2021 right after the GameStop short squeeze. The references to Reddit users planning new attacks, Covid stimulus, the surge in trading-app downloads and “the dangerous market peak we are in” reflect that moment.
After the short-lived success of an organised group of small investors who used Reddit to put Wall Street and the funds holding bearish positions in check, the group is threatening to do it again. There even seems to be interest in copying the move in many other countries, including Spain.
In Spain, however, the CNMV (the Spanish securities regulator) has already warned that a move like the WallStreetBets and GameStop play would be considered market manipulation, and those involved could face up to six years in prison.
In the United States, though, Reddit users are still planning to go after other stocks where hedge funds have bearish bets (short selling). In any case, whatever country it’s done from, the first battle caught fund managers off guard. They’ve been forced to watch these movements more closely and even to close some short positions. But once they’re ready for what comes next, we may see them not only avoid losses but fleece those users.
And you should know that you, as a retail investor, can also profit from these purely speculative moves.
See also: How to make money when the stock market falls: products for going short
How to profit from the trades of WallStreetBets and Reddit users
In stock market investing there’s a saying attributed to John Maynard Keynes: “The market can remain irrational longer than you can remain solvent.”
The point is that WallStreetBets players make short-term bullish bets on companies that have medium- and long-term bearish bets against them, because fund managers know that in the long run, a company’s fundamentals rule.
Here, institutional investors face not only the risk posed by organised groups of investors, but also the huge amount of monetary stimulus that has been pumped into the markets as a result of Covid.
It’s a fact that more and more people have downloaded stock trading apps, which in itself shows how dangerous the market peak we’re at is, but that’s another subject.
We could say that the fundamentals of listed companies matter less now, and that investing has to be more technical than anything else. This is where the hedge funds holding short positions on some companies need to innovate. And in fact, they’re working on it.
The danger for WallStreetBets and Reddit investors
Their bets are placed on companies that are struggling to survive. GameStop was one of the stocks chosen by short sellers because its fundamentals suggest its business will have trouble staying afloat.
That’s why fund managers and their analysts decided to bet against those shares.
Reddit users can inflate the price of these stocks, but fundamentals are fundamentals, and the company’s intrinsic value doesn’t change.
We’ve seen how thousands of small investors wrecked the hedge funds’ short positions, but what would happen if a few hedge funds decided to team up to protect their bearish bets?
Remember that on Wall Street there’s something of an open secret. In investor circles it’s called the pact of titans: nothing more than an agreement among funds not to take each other on. Imagine for a moment that what happened with WallStreetBets happened every day between investment giants betting billions against each other.
If such an alliance happened, it would simply amount to doubling down on the bearish bet at the peak of the rally. After all, we know that for a company with poor fundamentals, it’s only a matter of time before the market puts it in its place.
This is one of the ways the big funds could make thousands of investors lose a lot of money: investors who are playing at manipulating the market and taking on the very people who invented market manipulation.
See also: How to invest when you’re young, inexperienced and don’t have much money
How can you, as a retail investor, profit from GameStop- and Reddit-style moves?
If a company is expensive at $50 and we believe it should fall to $20, then after a move like this one that takes the share price to $200, the potential gain is much bigger from that $200 peak.
As GameStop’s share price chart showed at the time, in the end a stock that isn’t worth much returns to its level, however artificially it’s been pumped up. These thousands of investors posing as anti-establishment rebels really want to make money, and fast if possible. They won’t hold these shares in their portfolios for long, because they know the prices are going to fall.
And that’s an opportunity for the small trader to make money from these short-term moves. All they have to do is let the organised users buy and push the price up, open a bearish position, and the market (if not the hedge funds) will end up taking the stock back to the price it deserves.
A company that isn’t worth much eventually sees that reflected in its share price. Remember that in stock market investing, the most profitable thing is usually to go against the crowd, because one way or another the crowd ends up losing its money as its appetite for speculation grows.
So it doesn’t matter whether the investment funds or the WallStreetBets kids win. Once you understand how the game works, the attentive retail investor can profit from this move. And legally, too.
Featured image: Will Buckner, CC BY 2.0, via Wikimedia Commons.
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