Trading Becomes More Politicized as Bears Get Pounded

Trading

The alleged attack on short selling hedge funds by amateur traders is stirring a lot of unrest among an uninformed public, including politicians. Understanding these things does help.

In spite of how many people invest in the stock market, there is much confusion about how these things work or even are supposed to work. This can lead to some pretty twisted views, such as ideas that we have a duty to suppress the smallest of investors among us so that multibillion dollar hedge funds may be better protected, from the consequences of the free market no less.

The recent meteoric rise of GameStop and several other exposed stocks, spurred on by a lot of buying interest from very small investors acting collectively by placing trades through platforms such as Robinhood, are being demonized, where the home team in this drama in the view of many have been large hedge funds who have taken massive short positions in these stocks and have paid the price for their mistakes.

The rhetoric that has emerged from this is very disturbing, where there is even talk of halting these stocks for extended periods, and this view is not just held by those who know nothing about securities, we are also hearing it from people like Massachusetts state securities regulators who are at least supposed to have a decent idea of what securities trading is supposed to be accomplishing.

While there is always all sorts of foolish talk that goes around when it comes to securities trading, this is much more than just talk, as this has resulted in the shocking action of both Robinhood and Interactive Brokers going to the extreme measure of halting trading on GameStop. This might not seem like a big deal to people but is a very serious action that is very much in need of being addressed, even if the issue is only one of capacity as the brokerages are arguing.

This view in favor of halting in any way is very misguided. It seriously calls into question the level of understanding that people who stand against the natural processes of the ebb and flow of the auction process that determines the price movement of stocks, to realize that the task here is to assist the orderly exchange of shares between market participants, not to interfere with this and certainly not to simply prohibit it because they neither approve of what is going on nor understand it.

It is incredible that those being attacked as a result of these moves include the long players, these little investors that have been trading completely honestly, the ones that these platforms have sought to stifle lest they bid up the price of this and similar stocks even more than they have. We’re not sure why this would ever be seen as bad in any way, as these are usually seen as happy stories, especially when David ends up making a lot of money while Goliath pays a huge price for his decisions.

Goliath actually should have seen this coming and these people only have themselves to blame for being on the wrong end of these bad trades. Short selling is already riskier than trading on the long side, even though stocks can lose value pretty quick as we saw nearly a year ago with the Covid crash.

You can lose a lot more on the short end though, much more than just losing all of your money like with long positions, even though, like with long side trades, you can cap your loss at any time and do not have to stubbornly cling to your positions to the point of being hammered into oblivion, at least if you have not set yourself up for this by holding positions so large that you have no recourse when the worst happens because you just can’t escape that quickly.

Harry Houdini locked himself up tight, the water came, much more than planned for, and this time he wasn’t so lucky because it takes a long time to unlock all those padlocks, and when the water rises this fast, you just don’t have time to do it or anything even close.

Once we got commission-free trading together with the ability to trade fractional shares, this really opened up the market, and while we may think that those who gain entry to stock trading due to now being able to trade fractions of shares might not even be worth paying attention to, and especially now much more power individual traders now have without having to pay commissions, they sure are paying a lot of attention to this now, and such a thing does significantly add to the risk of short positions in certain stocks, ones that are highly leveraged on the short side like GameStop and others.

The goal of securities markets is to seek to expand liquidity, and this is the only reason they exist in fact. If you own shares of a privately held company, one whose shares are not publicly traded, it is difficult to find a buyer for your shares, especially if you only own a modest amount. Markets bring buyers and sellers together, and this is the case with the stock market or any other market, supermarkets for instance where people can go and buy groceries rather than having to depend on trying to find these things on their own, from visiting farms for instance.

What this really serves to do is to make the exchange of items of value more efficient, and one of the ways that securities markets do this is to allow for what is called price discovery. Let’s say you want to sell your car and put a for sale sign on it. A few people may drive by and see it and someone offers you a certain price. There may be people across town who will pay more, but they are unaware of your deal, and you are unaware of their desire to buy it or what they would pay for it given the opportunity.

You put the car up for sale in an online marketplace where people visit that are in the market for cars, and this not only has you reaching the market much more effectively, you can also see what other people are asking for their cars and what they end up being sold for and this much better process of price discovery makes the exchange of these items much more efficient.

This is what happens with publicly traded stocks as well, where everyone that is interested in buying or selling these securities are brought together electronically to bid on stocks that they want to buy and offer stock that they want to sell, at whatever prices they want. As the deals get made, this gets recorded and we get our charts on how prices are moving with particular stocks or bundles of them held in stock indexes.

While some may accuse certain participants of speculating, all stock trading is speculation by definition, whether this speculation is on the long or short side, or even if the goal is to hedge. You might hold long positions in stocks which you are looking to offset the risk with options, where if the value of your long positions decline you can make a profit from the options increasing in value, but all of this is dependent upon the future expectations of the price of these things, nothing more and nothing less.

We Won’t Find a Rational Basis for Investing Without Being Rational

The comment that stands out the most during this current debate is that the trading of these white-hot stocks and their subsequent movement has “no rational basis,” and this is actually a view held by many on Wall Street, even though it is completely absurd. Absurdity does not serve as any sort of deterrent with these people though.

The rational basis for someone taking a position in a stock is that they reason that their position will increase in value to benefit them somehow financially, whether that means expecting to sell at a profit later, to buy it back at a lower price later if it is being shorted, or to move in such a way as to reduce the potential for losses with other positions.

That’s the rationale, and we are even left to guess at what else is supposed to be behind these things or these movements in price. You might be holding something that has only averaged a few percentage point gains per year and see something explode to the upside and say that’s not rational, but prices move in the manner that the market dictates, not someone’s belief about how far something is supposed to move.

It is completely irrational to think that whatever assumptions that you wish to make about the movement of stock prices apart from the movement of prices somehow matter, and especially when you are shown to be so brutally wrong. This is not unlike seeing it being hotter than the weather forecasters predicted and then thinking that Mother Nature is not being rational because it is supposed to be governed not by nature but by the mistaken beliefs of certain people.

The movement of GameStop and other stocks that have become extremely hot lately are perfectly rational in fact, but only if you have even the slightest idea of how stock prices are actually set. The explanation behind all of this is a very simple one, as it all comes down to supply and demand, what drives all markets.

When demand exceeds supply, those looking to sell their shares can sell them at a higher price, as those who wish to buy them are willing to pay more. When the reverse happens, when the pressure is on the sell side, stock prices go down. None of this is remarkable in itself, even though the magnitude of the shift in supply and demand can be, as we are seeing with these fast moving stocks.

We have come a long way from the ticker tape days, where investing in stocks was limited to the wealthy, with both high minimums and high commissions. This was the height of market illiquidity. We no longer have either minimums or commissions, and also have placed access to stock markets in the hands of anyone with access to the internet, where we have now reached the ideal as far as access and liquidity goes.

This can never be a bad thing. If someone wants to invest a dollar in a stock, and there’s a way that we can let them do it, we definitely should, as this is what security markets do, to bring people together to trade stocks. While there may be minimums that need to be set for practical purposes, if we can process these trades, we need to in order for markets to fulfill their mission. It is the ability to trade these stocks that is the objective and the good that free markets seek, and if we can allow anyone to do it with any amount they want, where no trade is too small, that’s achieving the ultimate, where stock markets be all they can be.

We aren’t entitled to view the process as serving one person’s interest over another, favoring big hedge funds over extremely small investors without real merit, or preferring those who do not want their positions to be subject to the normal risk of investing and seek undue protection against it, which is the accusation that is usually used against short sellers generally.

Stock market regulation is at least somewhat biased toward the long side, which is completely inappropriate, and people who may be unwilling or unable to manage their own risk and take on more of it than they should, cannot rightly look to regulators to punish those who wish to take a different approach to trading because they are unwilling to sell when they perhaps should, or if what transpires in the market does not fit their strategy so well.

We certainly should not be favoring hedge funds that clearly took on way too much risk, by blocking micro investors or any investor from purchasing shares of the stocks they own, more than it is healthy for the hedge funds to see. This is not justice, it is corruption.

The addition of all these micro traders has served to both add more liquidity to the market as well as add more upside pressure to it, just as if “normal” investors came into more money and had more to invest due to economic prosperity. If you are an investor, you root for these things, and even depend on them, and it should be pretty easy to understand that the more money we have that wishes to be long stocks, the higher the demand for them will be, and the higher they will trade at as a result.

Some may feel bad for investors in these hedge funds that have literally lost billions of dollars in these smaller stocks that they had such disproportionate short positions in, but with speculation, you pay your money and you take your chances. If the risk goes up, as it clearly has with all this additional upside pressure when you’re betting on something going down, and you ignore it and fail to adapt, you only have yourself to blame, and we should never use pressure or regulation to seek to punish others for your mistakes.

All stocks have a certain amount of short interest, ranging from a few percent with stable and liquid big cap stocks, to the majority of shares of a stock being loaned out to short sellers, or in the case with GameStop, 140% of the float, a truly ridiculous amount that is just begging for trouble. This horrible strategy has now been exposed and the trouble has arrived.

In many of these cases with stocks that have a lot of short interest, meaning that a much higher percentage of a stock is loaned to short sellers, the speculation on the short side may not even be a reasonable one irrespective of the risks, and when it isn’t, when the stock does not move down, the bomb has been armed.

While it makes sense to follow prices down when selling short, when you short and this doesn’t dunk it, you are in big trouble and are a sitting duck to upward price momentum, and especially to speculating that creating momentum against your positions will cause them to collapse against themselves as your delayed buying becomes forced and drives the price up much further, the dreaded short squeeze.

What short selling does, when investors borrow shares from others and sell them now and promise to replace them later by buying the stock and returning the shares to their owner, is to add downward pressure to the stock, creating artificial excess supply we could call it. We might initially think that this is a bad thing, interfering with the actual supply and demand of a stock and unduly harming the bulls and unduly helping the bears, this actually adds to the efficiency of the market by permitting the involvement of those who wish to speculate on price decreases rather than just be limiting to speculating on rising stock prices like the long side pens you into.

No one is forced to pledge their stocks, and while individual investors are usually unaware that their shares have been sold by someone else, the seller is financially responsible for them, and this responsibility falls upon the broker when the seller is unable to cover their positions.

Ultimately, we end up in the same place when the positions get closed out, people get their stock back and those who wished to speculate got the opportunity. This also serves to synthesize the shorter buying the stock low and selling high when they work and the opposite when they don’t, even though the selling occurs first and the buying later. In the meantime, it is important to account for short interest as this does tend to distort the market, having the exits and entries transposed like this.

We Need to Properly Understand the Risks Before We Can Manage Them

To show this, let’s say a stock trades at $100 and then has its short interest greatly increased, where, say, 20% of the stock’s outstanding shares are shorted. We’ll say the price remains at $100 to keep things simple, and people even short moves that are moving against them so it may have actually gone up in price during this time, where the downward pressure of the shorting not only becomes offset by the upward pressure but the upward pressure prevails anyway.

You are now considering shorting it in our example and you look to the chart and see the price is stable, where it had been going up prior to all this and now the rise has stopped due to the short selling. If you don’t account for the short interest, you are making a big mistake as this is a stock that has not only been squelched by the exit part of it, we still have all these entries that are yet to be made, bullish pressure laying in wait. You don’t want to be around when it bubbles to the surface or is forced there where short sellers start cutting and running, similar to selling during a panic. This panic is not only just as real but even more dangerous.

If we want to be regulating anything here, beyond things like taking away the right to short on a downtick, which doesn’t serve to do very much, we may want to consider setting caps on short interest to limit these potential storms when you delay all the upper pressure like this. This would serve to limit the impact of short squeezes, if that is our goal, although we do need to wonder why we should, as a transparent and efficient market transfers the risk to the participants and seriously question why market participants warrant being coddled in any way, and especially not large hedge funds.

If they make bad decisions like not accounting for short interest properly, not managing their risks, hedge funds should surely be the ones that pay the price for these mistakes, and we shouldn’t be looking to protect them from free market activity. We shouldn’t be censuring them either, because it’s their money, and we should not be telling people how to invest whether it’s a big fund or a kid on Robinhood.

Amazingly, in the aftermath of these big moves with heavily shorted stocks, the guns have been pointed at not the short sellers but a bunch of tiny investors trading very small amounts. Apparently, traders communicating with each other on social media and sharing their ideas about hot stocks just isn’t acceptable to some people, particularly people like Nancy Pelosi who thinks that these young people are turning the stock market into a “casino.”

Pelosi surely has no idea how hilarious this statement is, but this is exactly what everyone who participates in the stock market does, placing bets on the future movement of stocks. This is the purpose of public stocks, something to place wagers on, and they do not even have any other function. Depending on how you define casinos, if they are places where people wager against each other, this is exactly what exchanges do and all they do. If the betting gets too wild for your tastes, you can just move to another table.

Pelosi also worries about how this price movement will affect the company and its customers, which really exposes how she knows nothing about such things, as stock trading has nothing to do with the business world. The company got paid for its stock when it was issued, and once it trades on an exchange for the first time, it’s just the stock that the company sold getting passed around among traders for fun and profit.

The people that tell you that shorting stocks does not have any purpose in business suffer from the same delusion. They are right about that part, and their mistake is thinking that the long side has anything to do with business. Stocks are merely side bets on the business, nothing more, and people bet on its price both going up and going down, and both are equally legitimate.

Perhaps the most ridiculous comment we’ve heard about this is that we should not be allowed to short because this interferes in the free market. This makes as much sense as we should be allowed to buy stock but not to sell it because selling it would interfere with the free market. This is what you call a blinding degree of bias to the long side, and in spite of most people being on the long side with their investments, that’s not a reason to seek to restrict free markets to favor them.

It is when you do not understand any of this that you risk getting into trouble. Questions such as “why is my stock valued so low” in contrast to how the business is doing reveals a complete lack of understanding about stocks, because the betting and the betting only is what determines stock prices. There are no exceptions, nor are any even possible.

There is nothing wrong with this, and business works the same way, betting on making money from a business you may start and winning or losing depending on how your bet goes. Securities trading just makes this all more transparent and liquid.

This Should Wake People Up to What Actually Puts Stocks Up, Demand

The big difference with publicly traded securities is that you don’t bet on the businesses at all, at least not directly, and the only way you will profit is that if demand for the stock itself goes up, independent of anything else. The movement in GameStop’s stock during its explosion does not make sense from a business perspective of course, but the movement of stocks in general are not confined by these things either, and that’s the lesson that so many need to still learn.

Stocks go up in variable amounts relative to business results, and if not, investing would be so much easier, where all we would need to do is pore over these results and be guided with confidence. This is an illusion as it has no basis at all in fact. If you want to be able to predict the movement in the price of something, you need to look at what you are looking to measure.

These amateurs could teach these so-called professionals and the legions of people outside the profession that mistakenly think they understand stock trading a few things. Someone figures out that a stock that doesn’t usually trade very heavily has a lot of short interest and have basically caught the shorters with their pants down. They bid the stock up, and sure enough, it goes up, not due to anything that the company is doing but because people are buying the stock more, amazingly enough to some.

This is not bad, this is not wrong, this is how all stocks work. We just get to see it more transparently with these small caps. We have been watching the same thing happen to Tesla when everyone was scratching their head over their stock being worth more than any other carmaker while making so few cars.

Making cars or even making money does influence the betting, although many things influence the betting, and nothing influences it more than momentum. You see people bid up the price, you and others jump on and bid it up more, and it goes up exactly the amount that these market forces lead it to. Momentum does not just measure market action, it also in itself drives it, as people watch it rise and become more excited about making money from it, or see it go down and bail for that reason.

All this additional liquidity that is still coming into the market due to getting rid of commissions does scare funds, to the point where they are caught holding the bag after taking on too much risk and then want to blame it on the little people. Funds are at a huge natural disadvantage to individual small investors, and when these investors use this advantage against them, and they have neglected to account for any of this in their strategies, of course they are going to cry foul.

The narrative of funds has always been that investing is something that people should not try themselves, and they should instead listen to them and invest with them. They will even tell you that it isn’t possible to successfully time investments, even though, somehow, they manage to do it, although not very well, mostly due to their lack of liquidity.

Funds are like oil tankers compared to the speedboats that individual investors travel the investing waters in. Imagine that you see something that causes you to liquidate a position. You have $10 invested and you just pull out your phone and in seconds you are out.

Imagine if you had $10 billion invested in this instead. You want to get out, but it may take you months to turn this big tanker around. This is a form of liquidity risk and it’s a huge impediment to fund investing. You can and often get hammered along the way, so you prefer stocks don’t move too fast. Stocks that go up many times in a few days while you’re holding a huge short position is your worst nightmare, and billions of money have been lost by these funds from these high flying stocks lately.

These amateurs aren’t distorting the reality of stock trading, they are instead revealing it more, where those who are paying attention can benefit. Longer-term investors don’t mind short squeezes, nor does anyone on the long side sitting back and watching these things happen, and the real risk here is with the shorters and individuals who trade badly.

Like with all trades, some make money, and some do not, and we can’t just take away people’s rights to buy and sell stocks just because this shakes up our broken understanding or because funds took on way too much risk and it has now come home to roost by way of a perfectly legitimate process.

When you see Ted Cruz and Alexandra Ocasio-Cortez, who sit at opposite ends of the political spectrum, with Cruz being a champion of individual liberty and AOC being a radical socialist, agree on anything at all, this is noteworthy indeed. Sen. Cruz objects to our wanting to restrict trading with small investors as an affront to liberty, while AOC is angry that we are biased in favor of the financial elite over the interests of everyday investors.

We should not be favoring any investor, as it is the process that we need to defend, with not one side or the other objecting as the deciding criterion but instead what is fair and sensible. If people are bothered by what they see as excessive short selling in particular stocks, we can have that conversation, but people showing how risky this is should not be censured and restricted, they should be thanked.

Lots of people are demanding changes, and placing restrictions on short selling is definitely among them. The free market exacts its own price for mistakes though, and while some want limits on how much of a stock can be shorted, hedge funds have already been put on notice, and they got burned with several stocks ripe for the picking and got punished in a manner far beyond anything the SEC could dream of.

The restrictions that these brokerages imposed at least had something to do with the difficulty of providing the liquidity to handle these trades, as in spite of technology allowing people to get their trades filled in seconds, money does not change hands this quickly and brokers need to have the financial wherewithal to handle them. We can’t just let them shut the door like this either, so this does need to be addressed.

The idea that people sharing tips online such as this list of stocks that are horribly oversold by way of massive short interest needs to be stopped or even could be stopped is not something we could control even if we wanted to, and we most certainly should not. Information makes markets more efficient, and these gangs looking to exploit these mistakes made by hedge funds is exactly what markets serve to do, and the goal is always to maximize.

You also can’t tell people that they cannot share their ideas about trading, because while social media can be selective in who they wish to silence, as shredded as the right to free speech has become, the first amendment does apply to someone, and governments are that someone.

The biggest change will come by way of how hedge funds who like to park big short positions in distressed stocks approach this strategy going forward, being shown so convincingly just how terrible it is. Their relative illiquidity compared to individual traders has also been brought to light more, and while sharp traders have been taking advantage of this all along, social media has provided the means to have a single person with a good trading idea summoning a massive swarm of people looking to exploit mistakes, which has really put these funds on notice. Nature often finds its own balance.

Hedge funds use a wide variety of strategies to make money with securities trading, and people making or losing money is not only the central driver of this, it is its only purpose. Their limiting their short positions will not affect the real world, no more than people bidding up securities does, apart from changes in the value of portfolios. Part of risk management is anticipating events just like this, and hedge funds should know what happens when demand for a stock spikes, and just got a very expensive lesson.

Markets are as stable as they are because so many people are so effective in setting their own limitations upon volatility, ideas such as a stock’s business performance sets some sort of real limitation upon the price of its stock. When the market ignores these mistaken beliefs, as they just did with a number of stocks, we are shown the real power of momentum, and perhaps these things will spawn a shift away from institutional investing and its gross inefficiencies to a much more grass roots one, which will require people to actually learn about what they are doing. Let the learning begin.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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