What a difference a year makes. Last year, hedge-funders were throwing up their hands and complaining about how much harder it was to make money. Algorithms moved so fast and bought so much stock that individual active traders, even if they had lots of capital, couldn’t move markets like they used to. But who could have foreseen a pandemic that would put people in front of their computers for hours at a time, with no sports to bet on and an axe to grind against Wall Street?
Many small investors who discovered stock investing during the pandemic have benefited from the Robinhood app, which made it easy to trade. They have also been encouraged by people like David Portnoy, founder of Barstool sports, and other social media stars who insisted that stock investing is a fun and easy way to make money. No one mentions that it’s only easy on the days when the stock market goes up.
This growth in individual investors has led to some strange price swings. Over the summer, the stock price of the bankrupt Hertz car-rental company increased tenfold. This week, things got even more interesting, when the stock price of videogame retailer GameStop rocketed from $72.71 on Monday to more than $300 on Wednesday. One reason for the stock’s meteoric rise: people on chat groups like Reddit’s r/WallStreetBets, who encouraged one another to buy out-of-the-money stock options. This time, even large institutional investors got taken down. Melvin Capital Management, which shorts stocks, had bet that GameStop’s prices would fall; it needed to get a loan from the large hedge funds Citadel and Point72 to close its GameStop position. Redditors congratulated themselves for claiming a hedge-fund scalp, and Bloomberg’s John Authers called it an act of class warfare. A more likely explanation is that trading stocks can be fun and exciting—especially when you make money at it.
One reason these small investors have been able to move markets is that they are trading options of fairly small companies. When they band together and buy lots of call options on a single, smallish stock like GameStop, the market-maker (the person who facilitates the trade and keeps the options market-liquid) must buy more of the stock. Thus, even a retail trader’s behavior can have a big effect on the stock price. And when options are involved, everything gets magnified—both gains and losses.
Sudden ascents like GameStop’s are clearly a problem for active traders who base their bets on market fundamentals rather than Reddit chatter—but for most investors, there’s no reason to worry about their portfolios. Buying or shorting an individual stock and trading options are inherently risky activities. There’s a good chance something weird will happen and you’ll lose your shirt. This is especially true for smaller companies. Large hedge funds promise such big returns because they take on this added risk. Odds are, many of these new day-traders will lose money eventually, too.
If you stick to a well-diversified, passive index fund, this is not such a big worry. Reddit users would have a much harder time moving the price of the entire S&P 500.
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