Reddit Caught with Their Shorts Down

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Gil Gutknecht, Like the mighty Gulliver pinned down by the Lilliputians, the Reddit Raiders have had the giant hedge fund boys tied up in knots.

The suits were executing a classic short squeeze where they collectively shorted GameStop shares. It’s a time tested strategy where their shorts alone were virtually guaranteed to drive the stock price down. They consistently made hefty profits while the small shareholders lost big.

But a funny thing happened to the wolves on the way to this kill.

They ran into an army of small day traders, armed with laptops. A few did the research and shared it online with the rest. They discovered that the hedge fund hogs had gotten greedy. The pigs had apparently managed to short more shares than GameStop actually had outstanding. As we in the Midwest say, the pigs get fat and the hogs get butchered.

The hedge hogs were caught with their shorts down. About a week ago, the butchering began. You don’t have to appreciate a good pork tenderloin to find this all quite tasty.

When someone shorts a stock they are effectively selling the stock today with a promise to deliver those shares at some point in the future. They aren’t really investing. They are simply betting, betting the shares will go down in value. To ensure that they will be able to deliver those shares, they must borrow shares from someone who holds them. Brokerage firms loan the shares to cover these shorts for a fee or interest. The raiders knew that eventually the hedge funds would need to buy shares to square their short positions. Since there weren’t enough shares outstanding, they began to buy heavily. This drove the price up and up, creating huge losses for the hedge funds.

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By one estimate those potential losses reached over $70 billion on paper.

You may ask, do the brokers loan shares of current shareholders who have accounts with them? Do they collect fees for this? And do they inform current shareholders that they are lending their shares to the hedge funds with the clear intent of driving the value of their shares down? An even better question, how could these guys possibly short more shares than those outstanding? That sounds like naked shorts, which are illegal.

Everything the day trader raiders did was legal. All of the information they used was public information. They didn’t create the oversold situation. They simply exploited it. The hedge hogs and their broker enablers finally went too far. And they got caught…big time.

For reasons we do not yet know, stock trading platforms intervened. They began to limit the ability to trade stocks like GameStop. Chief among them was Robinhood, the very app used by many of the day traders. Robinhood’s motto was, Democratizing Finance for All. Comedy became farce. They would allow clients to sell the stock but they couldn’t buy. The only beneficiaries of this were the hedge hogs. Robinhood wasn’t alone, even vaunted Charles Schwab posted a bizarre statement on their portal which read:

In the interest of helping to reduce risk…we’ve put in place restrictions on certain securities. These restrictions may include increasing margin requirements or limiting certain types of transactions.

Schwab didn’t protect us when the COVID correction hit. So who are they protecting now, from whom and why? They have every right to raise margin requirements. But, do they have the right to limit certain types of transactions?

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NASDAQ CEO, Adena Friedman suggested that her exchange might halt trading of certain stocks to allow investors to “recalibrate.” In plain English, she would intervene to allow the big hedge funds to close out their positions, cutting their losses at the expense of small investors.

Did the big banks and brokerage firms lean on people like Friedman and perhaps new Treasury Secretary Yellen?

The stench of this is strong enough to offend noses on the right and the left. It demands Congressional hearings. Some people may go to jail. Maybe the SEC will finally put some serious restrictions on these short squeezes as well as the way the brokerage houses cover their shorts. In any event, these Reddit Raiders have struck a serious blow for the small investor.