The Long and Short of itSubmitted by Bond & Devick Wealth Partners on February 1st, 2021
The Long and Short of it
Many of our clients have happily lived their lives without knowing or caring about things such as Reddit or Robinhood or wondered why some stocks have been shooting to the moon lately, like AMC and GameStop. All of the above have been dominating the news lately and causing many people to wonder what is this all about? Here is the Long and Short of it.
Many people spend their days analyzing companies and their stocks. If they believe they have found an attractively priced stock whose company has solid prospects they may buy the stock, which in Wall Street parlance is known as “going long”. When you are long a stock, you own it.
There are also many people who spend their days looking for stocks they believe are significantly over-valued and whose companies have less than stellar prospects. Traders, many of them hedge fund managers, will short the stock, which means they sell stock in a company that the do not own (they need to pay interest to the broker) hoping the price of the stock goes down at which point they buy the stock to close out the transaction. If they buy back the stock at a lower price than they sold it for, they make money.
To make it more fun, many of these hedge funds borrow a lot of money (known as leverage) and sell a lot of stock they do not own in order to juice their potential returns when the stock goes down in price. However, if the price of the stock goes up, they lose money on the trade. Add in leverage and they could lose a lot of money on the trade.
Enter Reddit. This is an online news website in which members post content and images for the group to view which are then voted thumbs up or down by other members. The most popular posted content (those that receive the most thumbs up votes is shared widely with the members).
Robinhood. This is not the guy who steals from the rich and gives to the poor. It is a commission free stock trading app that is very popular, primarily with young, inexperienced investors who have smaller accounts.
A little R&R. What has happened over the past few weeks is that people on Reddit decided to gang up on the short sellers for a couple of different stocks, AMC (the movie theater company) and GameStop are two examples. United Airlines is another. The Reddit posts encouraging people to buy stocks of heavily shorted companies went viral and investors, primarily with small accounts using apps like Robinhood, got together, and made millions of trades in those thinly traded stocks, which caused their values to dramatically spike up. This made a lot of money for those who bought the stocks early. It also caused the hedge funds that were short those stocks to lose A LOT of money – purportedly billions of dollars of losses.
The fun and games continued for a while until Robinhood halted trading of a few of these stocks, which caused the price to plunge. Regulators are also looking into ways to discourage this type of investing. Trust us when we say that hedge funds and Wall Street have a more powerful lobbying group than the R&R (Reddit and Robinhood group). The regulators and Wall Street also have a vested interest to make sure that the derivatives markets (instruments like futures and contracts whose value is derived based on the value of another asset) functions properly. The 1998 debacle of the Long-Term Capital Management hedge fund that brought the global derivatives markets to its knees and of course the real estate crash of 2008 are examples of what can happen if the derivatives markets face undue and unexpected stress.
We do not know how this will end of course, but the odds are that small investors who tried to stick it to the hedge fund managers and Wall Street will probably lose money as the brokerage houses and regulators defend the interests of the overall market including the short selling hedge fund managers.
At Bond&Devick we believe investing for the long-term by staying balanced and diversified and not getting caught up in these anomalies is the best way to manage our clients’ portfolios.