By Former MoneyWise Staffer, Kelly Griese
Wednesday, February 3, 2021
For the first time in what feels like a long time, I’m writing about something entirely unrelated to the Coronavirus pandemic, so you know the news is big. Big enough to convince comedian Jon Stewart to join Twitter. Big enough to create agreement between Alexandria Ocasio-Cortez (AOC), Ted Cruz, and Donald Trump, Jr. Big enough to put GameStop, Blockbuster, and AMC back in news headlines. So unless you’ve been living under a rock, you’ve probably heard about some weird stuff happening with the financial markets in recent weeks.
It’s a wild story with a lot of moving pieces, and I’ve spent the better part of a week trying to figure out how to explain all that’s happening. I settled on one of my favorite phrases for inspiration, “keep it simple, stupid.” In this blog post, I’ll do my best to explain “shorting” and hedge funds without giving anyone a migraine. I’ll also explain how GameStop, Reddit, and Robinhood are involved. And then I’ll get around to talking about regulation and fraud prevention.
Short Sales, Options, Margin Trading
As I have told you time and time again, ALL investing involves risk, but some securities products and investing practices come with greater risk. First, some terminology.
- Margin Trading: using borrowed money to buy securities
- Options: contracts to buy or sell a stock for a specified price on or before a certain date
- Short Sale: occurs when you sell a stock you do not own with the expectation that the price of the stock will fall
The U.S. Securities and Exchange Commission (SEC) explains all of these terms in more detail in a new investor alert that was triggered in response to last week’s weirdness. These terms feel foreign to many people. The average investor will likely never think twice about such complicated and risky forms of investing, but now that these methods and products are in the news, I feel obligated to help you understand.
Let’s go back to short sales. There are some wonderful plain-speak explanations online, including this one from NPR, but here’s what you need to know. When someone “shorts” a stock, they’re essentially gambling on that stock’s performance, believing it will soon drop in value. The investor borrows shares of the stock and quickly sells them, let’s say for $10 a share. Once the value of the stock drops, let’s say to $5 a share, the borrower quickly buys back the sold shares and returns them to the original owner, while pocketing the difference. In this example, the borrower would have made a $5 profit off each share. But what happens if the stock value doesn’t drop? That’s when short sellers lose money, because they must buy back the shares at a higher cost.
Can’t Stop, Won’t Stop, GameStop
The second of the two scenarios above is what happened with GameStop stock. For those who don’t know, GameStop is a retailer of video games, supplies, and novelty items. The company is seen by some to be on a path to extinction, with digital sales overtaking physical sales. These apocalyptic forecasts for GameStop led to its stock being targeted by short sellers, who could have bought in at $18 per share on January 7. But it wasn’t long before some members of a Reddit forum called WallStreetBets took notice. Those “Redditors” started purchasing shares of GameStop stock (NYSE: GME), driving up the cost to a high of $347 on January 27. This massive swing in valuation is newsworthy enough on its own, but it was the impact on hedge funds and investing apps that truly captured attention.
Hedging Your Bets
Now I’ll pause in talking about all that unfolded to explain hedge funds. I’ll use Investopedia’s description. “A hedge fund is just a fancy name for an investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds.” It’s a group of investors who pool their money into a fund which is then managed by a professional. The idea is to maximize returns and reduce risk. Mutual funds aim to do the same thing, but hedge funds tend to be more aggressive, risky, and exclusive.
My Main Squeeze
What role do hedge funds play in all the GameStop stuff? Well, it seems the goal of at least some of the new GameStop investors was to hurt hedge funds that had bet against GameStop. This is what’s known as a “short squeeze.” The word short refers back to the idea of short sales, and the word squeeze refers to the pressure placed on the folks who initially shorted the stock. In the case of GameStop, one of the main hedge funds being squeezed is managed by Citron Research. The Redditors’ actions put pressure on Citron to buy back shares at a significant loss. Another hedge fund that was squeezed is managed by Melvin Capital, which lost more than 50% in January. This all led to a flurry of commentary on social media—complete with memes—that only heightened the buying frenzy.
Robinhood Has Entered the Chat
Many of the Redditors used investing apps to purchase shares of GameStop. One of the more popular apps is Robinhood, which offers commission-free trading in stocks, options, and funds. The high trading volume with GameStop and several other stocks led to Robinhood making the decision to restrict transactions. Robinhood cited financial requirements, including “SEC net capital obligations and clearinghouse deposits,” as mentioned in Robinhood co-founder Vladimir Tenev’s Twitter feed. Tenev went on to say, “We did this because the required amount we had to deposit with the clearinghouse was so large—with individual volatile securities accounting for hundreds of millions of dollars in deposit requirements—that we had to take steps to limit buying in those volatile securities to ensure we could comfortably meet our requirements.”
The whole ordeal caught the attention of a number of high-profile people, including celebrities and politicians. On January 28, U.S. Representative Alexandria Ocasio-Cortez (D-NY) called on Congress to investigate Robinhood, and her Tweet about it was shared by Senator Ted Cruz (R-TX). Congress has not taken any action at this time.
The Role of Regulation
And so began the argument over free market versus regulation, with everyone pointing fingers. Robinhood says it was forced to restrict trading because of the SEC. Redditors say Robinhood was doing the exact opposite of the fictional character for which it is named by trying to keep billionaires from losing money.
Robinhood isn’t alone in restricting trading. Several self-service investing platforms did the same thing. Regardless of whether they did so to meet SEC requirements, retail investors were not pleased. The Redditors and their supporters argue they were just taking advantage of the system and playing the same game as hedge fund operators. This led to additional criticism about how financial markets are regulated.
Last Friday, January 29, the SEC released a statement saying it is, “closely monitoring and evaluating the extreme price volatility of certain stocks’ trading prices over the past several days.” The statement did not mention Robinhood specifically, but the SEC said it would, “review actions taken by regulated entities that may disadvantage investors or unduly inhibit their ability to trade certain securities.”
Avoiding Loss and Fraud
The drama above will likely end in financial losses for a great many people. The Redditors and those who jumped on board could lose money once GameStop stock drops. The hedge fund investors could lose money in the interim if they’re unable to hold during all this instability. Sadly, many of you could lose money as well, because a number of pension plans hold positions in hedge funds. CNBC points to data from the Center for Retirement Research at Boston College, which shows that roughly 7% of the $4.5 trillion in state in local pension plans are allocated to hedge funds. These pension plans support 14.7 million workers and 11.2 million retirees. Simply put, you could lose money without ever even knowing about the GameStop saga.
Some financial loss is out of our control, but there’s a lot we can do to protect our money. Start with these simple tips:
- Don’t take unnecessary risks. Risk is the chance you take that you will lose money or that your money will lose value by earning less than the rate of inflation. We all have different levels of risk tolerance, and you should be investing based on your personal preferences and financial goals.
- Diversify. “Don’t put all your eggs into one basket.” No investment performs well all the time, so you should spread your investments around to reduce risk and increase your overall return. To learn some diversification strategies, check out Investopedia’s page on the topic.
- Investigate before you invest. Perform a Registration Search and look at company filings on the SEC EDGAR website. You can also contact the Indiana Securities Division by calling (317) 232-6681 or visiting the Indiana Securities Portal.
- Think long term. Understand that while there are fluctuations, in general, the market has trended up over the long term. Consider the timeframe for your investment goals – when do you hope to retire, or semi-retire and pursue your own hobbies or interests full time?
No investor education blog post would be complete without the most basic warning about investment fraud and how to avoid it. Constant vigilance is key, so be on the watch for these red flags:
- The seller isn’t licensed or registered. Licenses and registrations can be easily reviewed using the registration search on the Securities Portal. Individuals and firms in the financial services industry must meet certain requirements in order to be licensed. Another valuable resource for determining whether an individual or company is registered is BrokerCheck by FINRA.
- No written information is provided. Ask for a prospectus or disclosure statement. These are legal documents that provide details about an investment offering. The prospectus, or “offer document,” will contain the facts and information you need to make an informed investment decision.
- The sales pitch is rushed and aggressive. You should be suspicious of any seller who pressures you to “act now” or says this is a “limited time offer.” If they are pushing you to make a decision immediately, it is probably because they do not want you to find out that the investment is a scam. Also, anyone who won’t take “no” for an answer is probably up to no good.
- The seller is hesitant to answer your questions. Con artists seem to have an answer for everything, but if your questions make them uncomfortable, it’s best to walk away.
- The seller promises high returns with little or no risk. Returns and risks go up and down together. If you want a chance at high returns, you have to accept high risks. If you’re a low risk investor, chances are the returns will be modest. Also, there is no such thing as a “no risk” investment. All investing comes with some risk attached.
- You’re asked to keep this “exclusive” offer a secret. Con artists don’t want to be caught, and so they pick their victims carefully. They don’t want you telling someone who might uncover the scam.
What happened with GameStop is an anomaly. If you are new to investing or haven’t yet started saving for the future, don’t let this strange story scare you away from the financial markets. Investing is still the best way to grow your money and save for retirement.
Also, please don’t blame me for what happened just because I wrote about The Economics of Animal Crossing! I saw some memes pointing fingers at the Nintendo Switch game, which has a stock market element built in. Plus, something good came out of the GameStop story. A Minnesota man who made money off GameStop stocks bought and donated Nintendo Switches and games to the Children’s Minnesota Hospital in Minneapolis.
If you want to read more about all that happened the past two weeks, check out this list of additional content I read to help me write this blog post.
CNET – Robinhood troubles
The Verge – AOC and others call for investigation
CNBC – Why the GameStop frenzy may hurt retirees
CNN – Robinhood to ease trading restrictions
SEC – Thinking of day trading? Know the risks.
FINRA – Social sentiment investing tools – think twice before trading based on social media
Blog topics: Archive, Fraud Prevention, Investing
The MoneyWise Matters blog has a wealth of information about managing money and avoiding fraud. You can look through the complete archive here.