What pro traders, the Reddit crowd and regulators may do next in the GameStop short squeeze saga

What’s next for the Reddit crowd? Wall Street seems unsure. 

The “blow-out-the-short-sellers game” is showing signs of exhaustion, but the ramifications are only just being felt.

What traders can’t agree on is what will happen next. There are four buckets of discussions: How will traders/hedge funds react? How will trading platforms react? How will regulators react? And what’s the next move for the “kill-the-hedge-funds” traders?

A major hedge fund losing money gets the attention of Wall Street. Wall Street does not want to get steamrolled on this short-squeeze game again. Many short sellers like Melvin Capital have already unwound their short positions.

Another response from dealers may be to increase option prices, particularly on out-of-the-money call options. 

But many are still trying to profit from the game. “Anyone who knows anything about options is trying to figure out how to sell GME options,” said Larry McMillan, an options advisor with McMillan Advisory. 

Why? “There haven’t been too many short squeezes like this in recent history.,” he said. “As long as people believe fundamentals matter, they are going to be selling short stuff like GameStop.”

He noted that with GameStop stock trading at $260 in after-hours trading Thursday night, the $260 call expiring Feb. 19 is selling for $107, which means it would have to be above $367 to make money. The put at the same strike price is selling for $150, so it would have to go below $110 to make money.

“The issue, is how to do this without leading down the road to ruin?” he said. “It’s highly risky but definitely possible.”

Online brokers like Interactive Brokers and Robinhood have put the brakes on trading in individual stock and options on many of the heavily shorted names. TD Ameritrade is raising margin requirements and preventing shorts on these names. Robinhood said the decision to restrict trading was a risk-management choice to meet “financial requirements, including SEC net capital obligations and clearinghouse deposits.”

While Robinhood has faced considerable criticism from many traders for its actions, Global Markets Advisory Group’s Charles Dolan said the online brokers have significant reputational risk.

“If I’m the CCO [chief compliance officer], I will be very conservative and overreact rather than underreact because it is easier to fend off an angry customer than fend off an angry regulator,” said Dolan, whose firm provides strategic advice on market structure and regulatory compliance.

Robinhood said it will resume limited trading of previously restricted securities on Friday.

You know it’s a strange situation when ultraliberal Rep. Alexandria Ocasio-Cortez and archconservative Sen. Ted Cruz agree there should be hearings about Robinhood’s decision to block retail investors from trading. 

Rep. Maxine Waters, D-Calif., chairwoman of the House Financial Services Committee, and  Sen. Sherrod Brown, D-Ohio, incoming chairman of the Senate Banking Committee announced they intend to hold hearings.

UBS’ Art Cashin suggested that this could be a rich source of investigation: “The chat book revolt against the hedge funds might not be filled with little guys but rather some bigshots who are portraying themselves in anonymity as the little guys. Only an investigation will tell.”

It’s a far more delicate issue for regulators like the SEC, FINRA, and CFTC, which cannot easily resort to political grandstanding. 

“The regulators have to be thinking, how do you remove the incentive?” said Amy Lynch, a former SEC compliance official now with Frontline Compliance.

“The exchanges could step in and limit options trading by placing position limits or other restrictions, but they would need to do an investigation on what market rules need to be changed,” she added. She noted that restrictions and even outright bans on short selling are not unheard of:  Europe instituted a short-selling ban when the pandemic started.

Dolan stressed that there was a great need for a strong regulatory response: “Otherwise the notion of a fair and orderly market is in trouble. If value is divorced from price, what are you left with? The notion that people can stay insane longer than other people can stay solvent is a problem for the idea that a market is there to determine accurate pricing information.”

One obvious source of review is whether to tighten the stock-borrowing rules. ”Does it make sense to anyone you can short a stock with more shares than are listed?” said Global Markets Advisory Group’s Lou Pastina. The SEC could also clamp down on naked short selling, the illegal practice of selling short stocks without first borrowing the security.

If this is a movement? If it is, what’s the goal? If the goal is to stick it to hedge funds, there should be no allegiance to the idea of attacking short sellers. It is merely a means to an end. This will eventually not work, and there will be a need to move on.

But move on to what? Some think there will be attempts to target other weak points, others believe the community will morph into something different.

Stephen Mathai-Davis, who runs the all-AI trading platform Q.ai, has extensively surveyed thousands of online investors from different Facebook, Instagram, and Redditt communities, including WallStreetBets. 

While he disputes the idea it is a true “movement,” he says there are many shared characteristics.

“They are definitely countercultural,” he said. “There is a movement to the decentralized online communities where people are learning from each other. There is a distrust of Wall Street. They are very well aware that Wall Street thinks they are ‘dumb money.’ In the community, no one talks about mutual funds, they talk about individual stocks and ETFs. Some are very involved in options trading.”

In surveying this community, Mathai-Davis asked how much they trade, how they do research, and what they want help with.  

“We found out they needed help with three things. First, they don’t know how to trade in a dynamic trading environment. Second, they don’t know how to cut their losses. Third, they don’t know how to weight portfolios.”

Mathai-Davis is attempting to get the “community” to move away from trading stocks and start trading investment themes. “We believe in investing, not speculating in individual stocks. If you don’t have time to do research, we can provide that,” but he admits retail investors are still focused on individual stocks.

Ultimately, he believes the community is morphing: “Rather than using an old-fashioned mutual fund, everyone will ultimately have a separately managed account that is a bespoke solution. I believe that is where the ‘movement’ is going.”

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