WallStreetBets explained

TL;DR version: It’s hard not to laugh at a bunch of internet randos taking down hedge funds, but you should try. What’s happening is not good.

Less TL;DR version: When you buy Gamestop (etc.) at the say-so of WallStreetBets, you are giving your money to WallStreetBets’s founders and their friends, in the hope that in so doing you might be hurting some billionaires. As odd as it may sound to non-economists, those billionaires are actually providing a valuable service.

What’s going on:

One of the things you can do in the stock market is sell short, which is a way to bet that a stock’s price will fall. The way it works is you borrow the stock from someone else, and then sell it. This leaves you owning a negative number of shares. If the stock’s price goes up, you lose money, because you have to buy back the shares you owe at a higher price than you sold them at. But if the stock’s price goes down, you make money, because you can buy back in at a lower price.

It turns out that the people doing this are providing a valuable service, and we should be glad they’re doing it. I’ll come back to that later.

Now, the mechanics of how this works are important. The system is designed to prevent the following scenario: I borrow a thousand shares of Amazon and sell them. If the price goes down, I make money and buy a mansion. If the price goes up, I lose a lot of money, declare bankruptcy, and my creditors take the loss. To prevent me from doing this, I can only hold a short position as long as I have sufficient assets (called margin) in my brokerage account to cover my losses. If my losses exceed my margin, the broker demands that I deposit more money. (This is called a margin call.) If I cannot do it right away, the broker liquidates my assets to buy back the stock I borrowed.

Now, when I sell short, often the price doesn’t fall right away, even if I’m right that the stock is overvalued. Other investors might see things differently and keep investing in the stock, driving up the price. I still win, provided I can hold my short position long enough for the fundamentals to win out. But for me to do that, I have to have enough margin to ride out any temporary price increases. That’s why selling short is really only for the very rich. Without a lot of margin, you could be right and still lose because you get wiped out by a margin call before the price falls. The biggest players in this business are hedge funds.

That’s where WallStreetBets, a Reddit group, comes in. What they are doing is urging individuals to buy Gamestop, a surely overvalued stock that hedge funds are betting against. (Actually, they are urging people to buy call options, but that just complicates the story without really changing it.) This results in the price going up. The people who got in early — the founders of WallStreetBets and their friends — make out like a bandit. The people who got in later lose. That’s most of them; it’s a lot like a Ponzi scheme that way.

But the wrinkle here is: the losers don’t care, because they’re only in it to hurt the hedge funds. If they can drive the price high enough, the hedge fund gets wiped out by a margin call.

Now, ordinarily what WallStreetBets is doing would be an illegal pump-and-dump scam. But in this case it might be legal, because they aren’t actually pretending that Gamestop is a good investment. They are completely open about how they’re doing it just for yuks. If they get rich in the process, they’re fine with that.

Anyway, it worked. Melvin Capital was forced to close out its short position in Gamestop, taking a loss that is currently undisclosed but certainly in the billions. Melvin didn’t go under because it was rescued by other hedge funds.

Why it’s bad:

First of all, it’s morally wrong to spend your money purely to hurt someone else, even if that person is a billionaire. But let’s set that aside. Instead, I want to look at the service that hedge funds are doing us.

One of the greatest inventions in human history is the joint stock company. (In the United States today they exist as corporations.) It makes it enormously easier to start a business venture, because one can raise the capital from a lot of different people, each of whom has little risk, rather than all of it from a small number of very wealthy persons, all of whom are betting their fortune. It is one of the main reasons we have the bustling economy we have today.

But in order for the economy to allocate resources efficiently, we need stock prices to reflect companies’ true value. If Gamestop is over-valued, resources go into maintaining or even expanding Gamestop’s operations, when those resources ought to be going elsewhere. Inefficient resource use hurts our economy, which ultimately hurts employment and wages.

Stock prices are determined by investors, and, yes, speculators. If I see that a stock is underpriced, I buy it. If enough people see it the same way, the price goes up. The increase in the value of my investment is the payment I get for risking my money to assist the efficient functioning of capital markets.

The other direction is not as easy. If I see that a stock is overpriced, I can sell it, provided I already own it. But if I don’t already own it, how can I turn a profit on the research I did that determined it was overpriced? By short selling. Again, if enough people see it the way way, the price goes down. The increase in the value of my negative investment is my payment.

But there’s an important asymmetry between long and short positions. With a long position (buying stock), the most I can lose is 100% of my investment, because the price cannot fall below zero. With a short position, my potential losses are unlimited, because there’s no cap on how high the price can go. Thus, selling short is extremely risky. It is only going to be practiced by people who can afford to lose a lot of money.

What WallStreetBets is doing is making short selling much, much riskier. You no longer have to worry only about good-faith investors and speculators, but about vandals who are willing to throw money away just to hurt you.

You don’t care about the poor billionaires? I get it. But what you should care about the health of our economy. One of the things a healthy economy relies on is (mostly) efficient capital markets. And the way we get efficient capital markets is people (yes, mostly rich people) betting their own money whenever they see an inefficiency. If short selling goes away because it’s too dangerous, that ultimately hurts all of us.

In the short term there’s another serious risk. Even if short selling is too risky now, hedge funds have a lot of short positions already. They can’t just close them out, because doing so would just be preemptively taking the damage that WallStreetBets wants to do to them. If a lot of hedge funds start failing, that could spark another financial crisis. We saw how well the last one went, and this time the economy is already reeling from the covid lockdowns.

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