The best person does actually win

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Founder and director of investment website, Simon Brown. (Photo: Finweek)
Founder and director of investment website, Simon Brown. (Photo: Finweek)

The GameStop short squeeze saw hedge funds lose billions. We shouldn’t change the operation of the free (stock) market because of that.

As I write this column, GameStop has traded up at $500 pre-market, this after having been under $5 a year ago and under $20 just a week earlier. The story is that a group of traders on the mobile messaging platform Reddit, called WallStreetBets, decided to squeeze out the short sellers to send the share price soaring. And boy has it worked.

They had three factors on their side. A massive, short position (traders betting the stock would go lower) which was larger than GameStop’s entire stock issue. These shorts needed to buy the physical shares to close their trade. So, as the stock started moving higher, they had to push it even higher by buying. This is called a short squeeze. Reports are that more than $5bn has been lost by hedge funds that shorted GameStop.

The Reddit buyers also used options which require the buyer to place only a small amount of money to get a large exposure which the writer (seller) of the option must buy in the market to be hedged and neutralise risk. As GameStop’s share price moved higher, the option writer bought still more to remain hedged. This added to the buying pressure.

The third factor is of course that a stock that is flying (or crashing) attracts more interest and buying (or selling if it’s crashing). Put these three factors together and it makes for an astounding story to start off the year.

This has of course raised a lot of questions about regulation, potentially regulation of groups acting in consort. Some commentators have even suggested that a license be required to buy shares or maybe just to trade in options. This is absolute nonsense.

Sure, some large money has been lost by hedge funds, but when hedge funds crush it and make a killing on the market, why does nobody suggest new regulations?

I’d take it a step further and say that groups acting in consort is a function of the market. A stock rising is always the result of more buyers than sellers and the buyers may not know each other nor hang out in a group planning which stock they’re going to buy. But the industry does in a sense try and create consort.

Think for a moment of a fund manager who goes on TV and talks about a stock they own. Heck, there are even global investment conferences at which fund managers pitch their best ideas, trying to garner support for the idea and ultimately the stock. Singing the praises about what a great investment it is, they are talking their book (what they own) and hoping others will jump on the bus buying the stock and sending it higher.

Frankly, I’d rather a fund manager talk their book and telling me what you own and like. This is transparency and honesty.

Since GameStop’s share price reached $500 many US brokerage firms stopped clients from buying GameStop or options in the stock, allowing only the closing out of positions. The stock is now trading at $94. Margin requirements have been hiked at other brokers with shorts needing to pay 300%. In all cases the brokers say they are protecting clients and themselves, but it does raise the question of what happened to the free market?

The free market certainly does have rules, especially about disclosure and insider trading. But if we don’t cross those rules then maybe it is a case of the best person who wins. When engaging in short-term trading, my winning means somebody else must lose, otherwise where does my profit come from? Shutting down access to certain stocks seems very much to be a case of trying to protect certain sections of the market and this is a dangerous precedent.

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This article was written exclusively for finweek's 5 February newsletter. You can subscribe to the weekly newsletter here.

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