When Wall Street Becomes A Casino

This week’s Courier Herald column:

There was an interesting story from the business and investing world that briefly spilled over into mainstream news this week.  The events that transpired not only had the ability to affect major financial markets, but as is usually the case, will have political ramifications too. 

Shares of Gamestop, a struggling retailer that sells and buys video games and accessories, saw share prices spike from the high teens at the beginning of January to $483 at their peak.  The rally had long been predicted and some say orchestrated in the Reddit blog WallStreetBets.  It was what Wall Street calls a “short squeeze”, when investors that have shorted the stock have to cover their positions because of their infinite risk and the shares of the equity consequently spike.

A better understanding of their investment thesis is the diamond water paradox taught in entry level economics classes.  Water is usually almost worthless because it can be found everywhere.  Diamonds are expensive because they are extremely rare.  The values can quickly change because of supply and demand. 

A person dying in the desert would trade a bag of diamonds for a canteen of water.  Why? Because he has to have it to survive.  Nothing else matters at that point.

The laws of supply and demand dictate price.  If there are no shares available to buy (supply) and those with short positions have to do so (increasing demand), the price escalates quickly into “unreasonable” and definitely unsustainable territories. 

140% of Gamestop’s stock had been sold short – where shares had been sold with expectation they would be purchased to cover the transaction later.  Short sellers hope they can buy later at a lower price, but if prices go up, they owe the difference. 

A wave of buyers increased share prices and forced those shorting the stock to cover their positions. With more shares needed than were available, a stock that some were betting against as low as $4 turned into something they had to have at $400.  They had to stop their losses in order to survive, whatever the price. 

At this extreme, however, there were spillover effects.  Hedge funds short the stock had to sell other investments to cover their losses driving down the entire market.  Brokers forced restrictions on purchases, ostensibly to limit their own liabilities.

This stock has regularly appeared on the SEC’s “failure to deliver” list since September, indicating a broker did not delivering stock sold to the purchasing broker. This should have prompted regulators a potential problem with excessive short selling was growing.  Retail traders figured it out, and seized the opportunity instead.

Robinhood, a brokerage company that “gamified” stock trading, had been the brokerage of choice for many if not most of Reddit’s traders.  Again, regulators ignored the host of stories of young unsophisticated investors taking outsized risks not suitable for their experience level and often losing 100% of their capital…until they suddenly cornered the market and forced hedge fund losses.

Those restrictions at Robinhood, Interactive Brokers, and others allowed customers to only sell, but not buy heavily shorted stocks.  That left only those institutional traders who were being forced to cover their short positions available to buy, as retail investors were shut out of the game when it was getting really good.

The result is that the populist wing of the Democratic Party has found common ground with the populist wing of the Republican Party. In a familiar refrain, “the people” are coming after “the establishment”. 

There will be hearings.  There will be proposals for new regulations, despite many existing ones apparently going ignored.  There are also calls for new taxes – which would actually hurt retail traders – in order to save them.  No crisis will go to waste here.

As a disclosure, I’ve been following this discussion for months, and originally scoffed at the premise.  Eventually, it looked like it might actually happen, so I joined in late and traded up to almost the top.  I got out when it was clear the rules were going to change.  Unlike many leading the discussion on Reddit, I had no desire to forfeit profits to martyrdom.

What most of the business press still refuses to acknowledge is the retail traders were right. They only became on the wrong side of the trade when the rules were changed in the middle of the game.  The result is a lot of new investors have earned a distrust of Wall Street, as well as the media that covers them.

WallStreetBets forum members love to remind folks that pitch long term investment ideas that they are a casino.  They’ve just been given a hard lesson that at the casino, the house always wins.