Welcome to the “NFL”

By: Mike Willms

The Milwaukee Company, Director of Trading

In trading parlance NFL translates into “not for long”. Social media has instigated a rush into heavily shorted stocks as a populist attempt to bring the Wall Street hedge fund types to their knees through concerted buying of the companies with large short interests. Reddit’s WallStreetBets blog has several posters advising the purchase of stocks such as GameStop, AMC Entertainment, Express, etc. in hopes of running the market higher and forcing the short sellers to cover their short positions at a loss.

Clearly, it worked for a brief (or should I say “short”) period of time with GameStop reaching a print of $483 on Thursday last week. If you were short GameStop the pain was excruciating unless you were able to hold your short position until GameStop’s market price once again reflected its fundamentals.

That process is well under way, with the stock trading in a range of $55.59 to $91.50 on Thursday, and closing at $55.57, down $36.84 on the day or 39.86% at the time of this writing. Ouch!!! (A bigger ouch if you own it north of $400.)

The reality is most of the Reddit crowd was destined to lose money buying GameStop. Here’s why.

GameStop’s most recent 10-K shows 65.4 million fully diluted shares outstanding. Let’s assume that pre-December 31, 2020 the average cost at which those 65.4 million shares were acquired was $25.[1] The stock broke above $100 on January 26, 2021. A total of 370 million shares were traded on the days it closed at $147.98, $347.51, $193.60, $325.00 and $225.00. Given that, I suspect the average cost basis of Reddit shareholders is now well into the three-figure range, or essentially five times its pre-squeeze price.

Unfortunately, many of the new breed of social-media day traders are using margin loans to increase the number of shares they purchase. Borrowing money to purchase securities allows you to make money faster when prices are increasing. But that is true in reverse also. And, as prices decline, especially if the price drop is extreme and fast, you can lose your initial investment. Even worse, the security purchased is no longer worth the margin loan balance. Margin requirements are structured to avoid clients losing more than their original investment. The brokerage firm requests additional cash be deposited; otherwise, securities are sold to reduce the margin loan balance once account equity has dropped below 25%.

With the huge spike in volume, many brokerage firms limited outright trading, and massively raised margin requirements. For example, Robinhood, which is self-clearing, needed a large capital infusion, while firms utilizing a clearing firm had increased cash deposit demands.[2] When brokerage firms necessarily (and dramatically) raised the margin maintenance requirement for a short position in GameStop[3], the number of shares the Redditors could buy was slashed. The increased margin requirements also created pressure to sell. Even just a 100% maintenance requirement can result in a margin call and trigger a need to sell securities.

The speculators who had purchased their stock on its way up needed someone to buy the shares at a higher price to realize a profit. However, the longstanding risk-mitigation safety valves built into the markets generated forced sellers while simultaneously limiting the number of new investors. This is not a bad thing. Margin, net capital and clearing deposit requirements are designed to limit market excesses.

In short (there’s that word again), it was only a matter of time before GameStop started to revert back to its true fair market value. So, it was clear from the outset that this GameStop/Reddit saga was never going to be a wealth creator for most of the social media investor crowd. Great headlines were made, but in the “long” term, the market always returns to rational valuations.


[1] That’s probably too generous, given 144 million shares traded on 1/13/21 closing at $31.40 up $11.45. [2] A broker dealer can “clear” its own trades or contract with a “clearing firm” that clears and settles its trades. A self-clearing firm has a higher regulatory net capital requirement versus a broker who uses a clearing firm. Clearing firms require brokers contracting with their clearing services to post a cash deposit based on activity levels. Increased activity requires either an increase in net capital for self-clearing firms or larger deposit balances for firms using a clearing service. [3] One firm raised the requirement from 35% to 800% when the trading frenzy hit its peak.

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