FWIW # 13 Reddit Raiders February 2021

REDDIT RAIDERS

Before beginning this discussion, let’s take time to recognize we are all extremely lucky to be alive and experiencing these transitional times. Go back and review FWIW #6. The world is in the final phase of the fourth great secular economic cycle. On the other side of this transitional period will be the pleasant beginning of the fifth great secular cycle. Enjoy the uniqueness of the times. Live in a sensible manner, adhering to the basic principles you learned years ago, and the ugliness will not disrupt your life. Now, to the point of this FWIW.

How the markets work

Keep in mind the following facts that will never change as long as there are free and open financial markets:

1) There are and will always be market participants who believe any stock can go up in price no matter what the company does. These are called momentum speculators. They look only for stocks with share prices that are moving either up or down. Many professional speculators fall into this category.

2) There are and will always be market participants who believe there is a relationship between the underlying company’s financials and the price of the stock representing that company. These are called value speculators.

3) A market participant can buy any stock they want that is traded in an open market.

4) A market participant can sell any stock they want if they own it. If the stock is not owned, they can borrow the shares from another owner and sell those shares. There are two important factors in borrowing stock to sell (short selling): First, the borrower must add additional collateral daily if the share price goes up. And, second, the lender can request the shares be returned with 24 hours’ notice.

5) Regulators, brokerage firms, exchanges, and clearinghouses can change the rules of trading whenever they want. While this appears to be wrong and unfair, the ability to change the rules is crucial to you and me as investors. The financial markets are fragile because of the amount of leverage used by most participants and the guarantees given to all participants by the clearinghouses. Without the guarantees, the markets as we know them would not exist. While being able to suddenly change the rules seems unfair and some speculators hide behind it, changing the rules does not necessarily hurt anyone who is intelligent, even the Reddit Raiders.

6) The price of any security at any given time depends on the supply of the security and the demand for that security.

The markets for stocks include option markets (there are even options on options), mutual funds, exchange-traded funds (ETFs), and the individual stocks themselves. These securities, other than the individual shares, are called derivatives because they take their value from the underlying individual stock value. Conversely, these derivatives can influence the price of the underlying stock, so it is a two-way mechanism, depending on where demand is coming from.

What the Reddit Raiders are doing

The Reddit Raiders et al. are currently momentum speculators who have identified a weakness in the strategy of the professional short sellers (those who borrow stock to sell) and the markets’ mechanism. The Reddit Raiders are exploiting those weaknesses by concentrating their efforts on a group of stocks that have high short-seller presence. How do they know? Because the regulators require the short sellers to disclose their positions. Many professional speculators and executives on Wall Street dismiss these “retail” speculators as dummies who don’t know what they’re doing. Don’t believe it. The Reddit Raiders have made a brilliant move in concentrating their buying power on a select few stocks where they know the short sellers are vulnerable. Professionals say the Reddit Raiders don’t know the fundamentals of the companies. The Reddit Raiders know one crucial piece of information about the companies they own: Short sellers eventually have to give back the stock they sold, no matter the price they must pay for it. The Reddit Raiders don’t care about the company’s fundamentals; they care about the fundamentals and liquidity of the short sellers and the market mechanisms. These new-age speculators have done their homework.

Beaten at their own game

It has always struck me as strange for professionals, such as hedge funds, to publicly tout their ownership of individual companies or their short positions. If they did their homework correctly, a stock would eventually work out in their favor. By publicly talking to the business media about what they own or have sold short, speculators are trying to entice others to follow their lead, thus shortening the time it takes for their goals to be met. In other words, they are impatient speculators. While impatience is characteristic of speculators, it is not an investment principle. The Reddit Raiders have followed the playbook of the Wall Street professionals. Through chat rooms they share their knowledge, hopes, and ideas. While this concept is alien to me, it is a traditional crowd-working psychological concept that has been used since the first market was started.

The amount of whining coming from the Wall Street investment banks and professional speculators is embarrassing. Go back to the 2020 earnings reports for these banks and see how much of their profits come from trading. It’s a huge portion of the money they make. How do they make that much? By trading with both professional and retail speculators. They have been doing to others for years exactly what the Reddit Raiders and their followers are doing to them.

The focus on heavily shorted stocks in the stock market is not new. There have been short squeezes throughout history. There have been long squeezes as well. Generally, the squeeze comes from some market mechanism dynamic. In April 2020, the price of oil dropped to a negative price of $37 a barrel. Those owning oil on the day of reckoning effectively had to pay to sell their position. The business media, brokerage firms, exchanges, and regulators told the world the price collapse was due to a shortage of storage space in Oklahoma and too much oil. Those statements were proof the collective group was either ignorant as a rock or deliberately disseminating false information. It was apparent to any intelligent observer that oil market fundamentals were not the issue; it was a market mechanism dynamic gone wrong. Subsequently, the monumental debacle was proven to be due to a handful of commodity traders in Great Britain. Traders took advantage of a market mechanism that allowed them to put unusual pressure on the price of the commodity on the last contract trading day. This handful of traders made approximately $600 million that day. Perhaps other traders who followed their lead did as well. The Reddit Raiders are just exploiting a market mechanism dynamic that has been in place for decades and has been used by the professional speculators themselves, when it suited them. (See the last sentence of #4 above.)

The Reddit Raid: good or bad?

What many are missing is this simple fact: If the Reddit Raiders and their cohorts do not sell during a period when they cannot buy, the price of the stock will not have unusual pressure unless other speculators, not involved with the short squeeze, sell. Even then, if the short sellers want out of their positions, there must be other sellers for them to be buyers. Some speculators will take advantage of the squeeze to sell. Some traders will let the short sellers out, but only at a price deemed safe, which is likely much higher than the price when the stock buying was halted. Based on the price action last Thursday, there were obviously willing sellers, but who were the buyers after brokerage firms halted buying? Now, there is a path the investigators and regulators should examine. Were the short sellers allowed to liquidate their short positions by buying while speculators who wanted to buy more shares were blocked? Perhaps the regulators will tell us.

Finally, the only thing different in this short squeeze is the collective power of the retail speculator. When the Reddit Raiders have finished punishing the short sellers, they will move to the areas they feel are attractive on a momentum or value basis. This shifting of demand in a relatively stagnant supply arena like the stock market will lead to individual bubbles in stocks or their derivatives. Always remember: Bubbles create potholes, defined as stocks that are pushed down in price by selling to raise money for buying the bubble stocks. You can’t have one without the other. Investors look for the potholes because that is where permanent increases in net worth originate.

Cheer the Reddit Raiders on. They are doing good for all of us.

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