Wall Street Will Likely Never Be The Same After Gamestop Squeeze

Earlier today, jaws hit the floor when Citadel LLC and Point72 Asset Management announced that they would be investing $2.75 billion into hedge fund Melvin Capital Management.

This influx of cash, which came in exchange for non-controlling revenue shares in the hedge fund, helped to stabilize the reeling Melvin Capital.

This backstop is particularly astonishing given the success of Melvin Capital since its inception in 2014.

The fund, run by Gabe Plotkin, a highly respected former portfolio manager at SAC Capital, had returned roughly 30% per year from 2014-2020. Deep-pocketed investors noticed, and Melvin Capital was running over $12 billion at its peak, which is a pretty exceptional amount of money for a 7 year-old hedge fund to be managing.

The fund is known for its very prescient long plays and aggressive short plays.

One of those short plays was Gamestop, and this is where Melvin Capital started to get into trouble.

Gamestop's massive short interest (well over 100% of its outstanding shares) attracted the interest of a community on Reddit.com called "WallStreetBets".

This board, which now has over 2.2 million members, was originally known for its investing memes.

WallStreetBets was suddenly thrust into the spotlight last week when its members decided to take aim at a high short interest stock which had had some positive news recently - Gamestop.

What would happen if an army of retail traders started to buy up the shares (and calls) of a stock with a very high short interest?

The result? Gamestop went parabolic, trading as high as $160 per share, which is crazy considering that it was less than $5/share this past summer.

The fact that Gamestop had been so close to going out of business attracted many short-sellers, including Melvin Capital. As of their last 13-F filing, Melvin Capital owned over $55 million in Gamestop puts, which meant that they almost certainly had a massive short position as well (short positions aren't reported on 13F filings).

Retail traders, including those on WallStreetBets, started buying shares.

More importantly, however, they also started buying out of the money calls on Gamestop, which forced market makers to buy common shares in order to hedge their short call positions.

As the stock went up, short-sellers were feeling more and more pressure, market makers had to buy more and more shares to hedge, and Gamestop bulls bought even more calls and shares.

This resulted in the shares stampeding higher, and Melvin Capital very nearly went bust as a result.

The damage to Melvin Capital was severe.

According to the Wall Street Journal, Melvin Capital was down 30% for the year when they received their $2.75 billion injunction of cash. In addition, they lost 15% of the value of their fund in just a few days.

To make matters worse, all of the positions that Melvin Capital was short were targeted, ranging from Best Buy to GSX to Irobot to National Beverage Corp. All of these positions went wild on Monday.

Of course, other hedge funds jumped in as well, as word was travelling around that a major hedge fund might be in very big trouble as a result of Gamestop. It turns out that the fund was Melvin Capital, and there may be others that are teetering on the brink.

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In the past, hedge funds would eat the lunches of retail traders.

The stock market, however, is a very different place in 2021, mainly due to the explosion in popularity of zero commission brokerages like Robin Hood. Many people have discovered that they enjoy trading, and that the potential gains are much bigger than simply investing in the likes of Nike, Microsoft and Proctor & Gamble.

These retail traders have also realized their very awesome power, and Wall Street isn't going to like it. As evidenced by Gamestop, retail traders have the power to turn a short position into an absolute nightmare for a hedge fund. All of a sudden, retail traders have the power to start their own gamma squeezes and short squeezes, and they know exactly how to do it now - Gamestop has given them the blueprint.

In the past, hedge funds and investing groups would short a stock and then announce it to the world. Citron Research is a very good example of this, and they have done very well in the past.

Now the shoe appears to be on the other foot, as hedge funds and traders may be hesitant to publish their short research, for fear of being targeted and caught in a squeeze.

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Wall Street is going to moan and whine about WallStreetBets, as they are largely powerless to stop this wave of retail traders running amok on the markets.

They'd better get used to this new reality, however, as the genie is now out of the bottle and won't ever be going back in.

Filed under: General Knowledge