i. The Prisoner’s Dilmma

In short, the short sellers are not fully out, and the bulk of the short positions are just being transferred. To put things into the GME context, while hedge funds like Melvin Capital have reportedly covered their short positions, others will likely take their positions. This potentially explains the mere 26% fall in short interest shares despite an 8,000% increase since a year ago. Furthermore, despite the de-grossing, gross leverage (defined as short + long positions divided by asset under management (AUM)), which is a measure of the industry risk appetite, remains elevated which signifies that these rallies have attracted more short positions.

Soon enough, as the “buy and hold” or “HODL” maniac fades, this will likely turn into a prisoner’s dilemma scenario whereby it is to the benefit of all long-position holders to not sell, but being the first few to cash out brings the greatest benefit. As the first holders cash out, more gets hurt and this snowballs into a massive sell-down.

Those with call options will simply forgo their option premium and let their options expire. In the next phase, we could start witnessing delta/gamma hedges start to unwind and the market makers began to sell these shares (recall the call options sellers bought shares to hedge).

While some have bought into this based on the fundamentals, I believe some have bought in to stick it to the establishment and this is nothing more than a speculative bet for others. As seen from Bitcoin’s recent retreat from the US$42,000 high, misinformation about a double-spending problem that never occurred spooked many speculators to sell down the asset. When times are rosy, it is easy to present a united front, but once the pressure is on, fault lines will start showing. This is nothing more than human psychology.

ii. Consider the second-order consequences: Who is actually losing more?

Despite slew of good news over the past week such as FOMC meeting conclusively saying that more relief will be given, vaccination push will continue, interest rates to be kept near zero for the foreseeable future, and bond buying to be at least US$120 billion per month, the broader market has fallen sharply over the last week. This has spilled over from the Americas to Europe and Asia and will continue to do so if hedge funds continue de-grossing and the broader market becomes more fearful and uncertain. The market is a zero-sum game – for one to win, someone else must lose.

a. Short squeeze inducers win big, hedge funds lose big, others record temporary small losses  

Initially, as this short squeezes army gains and hedge funds/short sellers lose, the act of de-grossing will put immense downward pressure on the wider market will also cause the other little guys (retail investors) to lose.

b. Further squeezes could shake the wider market

Should this short squeezing / gamma squeezing trend continue, hedge funds are expected to actively manage risk by de-grossing, causing an even larger decline in share prices in the overall market, causing even more harm to the other investors in the broader market. This will continue to push short interest to an all-time low.

c. The combination of further hedge fund de-grossing, delta/gamma-hedge unwinding and record low put hedges could crash the market

But what’s next? Sure, there may be further room to run upwards – given the fanatical, near-cultish followings of other investment like Bitcoin, Tesla or Ark Invest, I have no qualms that this could happen. But what happens when HODL-ing stops? What happens if short selling interest remains (as it has despite the 1,800% rise)? Institutional money will always far exceed even the combined money of retail investors/day traders. While we may see some hedge funds collapse, others that replace their short position could stand to make a handsome profit in time to come. Eventually, this could become a game of musical chairs where the last holder loses the most, and the short sellers still “wins” in the end.

Following a probable further de-grossing, if the music stops and traders start cashing in, share prices of these stocks will start to fall dramatically as existing holders rush to sell off and option sellers look to unwind their hedges. With the sharp decline in short interest in a spooked and falling market, put option sellers will increasingly look to hedge their position, which could send the market in the completely opposite direction (hedge puts by shorting stocks). All these could combine to make the perfect recipe for a financial market disaster.

This is how a doomsday scenario could play out in the financial markets because of such trades and this is why I do not encourage readers from partaking in this.

iii. Read everything with a pinch of salt

Lastly, please take everything you read with a pinch of salt. I say this even for my own article. Given the limited time I have had to understand things, this was an opinion formed under the impression of all the information I have consumed thus far, which is likely be far from everything there is to know.

Likewise, I see a great deal of misinformation out there that cheer on this David versus Goliath trade. Even reputable finance vloggers like Andrei Jikh can mistake hedge funds for being the guys that engage in leveraged buyouts (LBOs) that caused the bankruptcy of several companies including Toys”R”Us, when this is in fact the doing of private equity; Likewise, others have also blamed hedge funds instead of the banks for the 2008 GFC. I know, potayto, potahto, but the point being that there will be a great deal of misinformation out there as people seek to push their agenda, e.g. the more people buying into it, the more it benefits existing holders. I see this in the Bitcoin/crypto community a lot and the same sort of behavior can be seen here as well. Influencers pumping and exciting the crowd so that it helps boost the adoption of the idea.

While I do not want to conclusively rule this as a case of misinformation, the restriction of buying activity on Robinhood, IBKR and Webull was also a highly controversial topic. On initial inspection, I think this could just be the clearinghouses demanding for increasingly higher fees from brokerage, which they eventually cannot keep up with, and hence Robinhood had drawn on the line of credit (take a loan). But other theories have also surfaced alleging collusion and market manipulation by the hedge funds whom the brokerages were heavily influenced by. I will not go into further details for the lack of concreteness on what is the truth.

To me, the “David versus Goliath” narrative is overplayed and is nothing more than sensationalistic journalism written to capture the readers’ attention and drive ad revenues / subscription revenue for the big guys. While my heart goes out to all those who suffered dearly in the 2008 GFC (such as those that posted on reddit) due to the disgusting greed of Wall Street, I think we need to understand what the second-order consequences could mean. By being greedy and unnaturally driving heavily shorted shares up, we could inadvertently cause many others (often those with imperfect information/knowledge) to experience the same plight that Wall Street left them in 2008 – I am not sure how different this behavior is from those of the “top 1%” that they claim to hate so much. As Ray Dalio puts it best, this incident is but one of the many examples of the growing divide between the “Haves” and the “Have-nots”.

To conclude, I am neither for nor against anyone trading such shares, as to me this is purely the financial market doing its work. However, I urge all readers to consider the wider consequences before acting. If you do decide to speculate/make educated bets, please only play with whatever you can afford to lose.