Whenever I see stock market news on the 10pm news, it never tends to be a good sign. And so it happened again last week, with reports coming from the US about large share price rallies in certain companies driven mainly by retail investors using social media and online investing discussion boards.

The story goes that these investors, portrayed as typically young, male, bored and/ or unemployed, have colluded to drive prices higher to inflict pain upon Hedge Funds (HFs) who held short positions in these companies.

It is the perfect story of heroes and villains, with the good guys banding together to take a win off the evil HFs who are shorting shares.

But it is really this simple? And who really wins in the end? Clue: It’s not normally the little guys in this game.

To understand this story a little more, I will need to explain in a bit more detail what actually happens behind the scenes. This may get a little technical but I’ll do my best to make it understandable.

So what actually happened?

Gamestop – an almost bankrupt chain of stores in the US selling video games – saw its share price driven up from $18 on 5 January to around $375 on 1 February. Nothing notable has happened to the company at all – they really have nothing to do with it. The share price rally was driven by a group of retail investors who use the online discussion board on Reddit called “Wall Street Bets” (side note: the clue is in the name).

The WallStreetBets (WSB) investors had seen that a number of HFs had a short position in Gamestop and decided they want to teach them a lesson by trying to drive the share price higher and force these HFs to take losses. And the crazy thing is it actually worked.

How did it work?

Three main reasons really. You have heard me talk previously about the main drivers of stock market performance – liquidity and positioning – and this is exactly what happened.

A bull market always attracts new investors who are tantalised by the idea of making ‘easy’ money. Just buy a stock and it goes up – what could be easier?

Since March, we have had very strong markets, especially in the US, and we have seen a rise of this retail investor.

This was further encouraged with new investing apps offering commission-free trading and looking very much like a video game. These apps actually make money by selling the information from these retail investors, allowing professional investors to ‘front-run’ their trades, a legal but very questionable ethical practice. It goes back to the mantra “if you’re not paying for the product, you are the product.”

Secondly, as Gamestop was a relatively small company, the daily liquidity in the shares was relatively low.

This has two effects.

First, it means the retail investors – if they can get enough of themselves organised – have a chance at moving the price because of this low number of shares traded per day. This would not be possible in shares like Amazon and Apple as they are just simply too big and the flows too large for any group of investors to have an impact.

The other impact of low liquidity is that it makes it harder for the HFs to buy back their short position without impacting the price.

And this is where the positioning comes in.

So if there aren’t many shares traded and the HF needs to buy back a short quickly, it will end up pushing the price higher, which is exactly what the WSB investors want to happen.

The third way the share price was pushed higher was the use and hedging of options. This gets a lot more technical in terms of what moves the price, but the WSB investors bought a number of very cheap, very speculative call options. As the price moved so quickly, the banks who took the other side of those option bets, had to buy more and more shares to cover these bets – adding more fuel to the fire.

In short, it was a perfect storm with a cascading effect. Once the share price started moving higher, it forced more buying into the system, and this feedback loop continued.

So score one for the little guys.

So what happens now?

Well this is the problem. For a lot of these new investors, this all feels like a game, and like all games, it becomes much more enjoyable when you’re winning.

And this wasn’t just a US phenomenon. IG Index, the spread-betting firm here in the UK, opened the most new accounts on one day EVER last Wednesday. This is the same IG Index that have a disclaimer on the front page of their website that says “75% of retail investor accounts lose money”. You can see where I’m going with this.

The stock market is not a game. Unlike a game it doesn’t stop. It has regulators who can change the rules. It has providers who can block access to shares. It has large, very profitable players who work in the shadows in the name of helping ‘stability’.

There is a system and over the years, the system has shown it will do everything it can to protect itself.

There are too many vested interests and the one thing the market regulators hate is stock market volatility. 2008/9 is too recent in all our minds, where it was stock market volatility that was one of the principal causes behind a huge global recession. Nobody wants that to happen again.

So whilst an inexperienced investor may make some money in the short-term and feel like they’re taking out their current life frustrations by “sticking it to the man”, they cannot win in the long-term.

The game they think they are playing will be changed, and the rules changed, and what had previously worked will stop working. And guess what happens when things stop working for investors? You lose money and sometimes very, very fast.

Financial history is littered with these scenarios and they always end up the same way. As my mother used to say: “It’s fun for a while, then someone gets hurt”. And no prizes to guess who that someone is going to be.

Adam

Please Note: The above is not personalised financial advice and if you’ve read this far, I don’t need to tell you that prices can go down as well as up.