The Man Who Took Down Hedge Funds
It’s one of the greatest trades of all time.
Right up there with Paul Tudor Jones’ Black Monday short…
George Soros’ bet against the British pound…
Or even Michael Burry’s “big short” during the financial crisis.
It’s a trade we’ll be talking about for decades to come.
A trader working out of his basement who goes by the name “Roaring Kitty” on YouTube turned a $50,000 investment in GameStop call options into a $50 million windfall.
That’s a staggering 1,000X return in just a few months.
Here’s how he did it…
How Hedge Funds Lost Billions
Since GameStop’s epic squeeze last week, Roaring Kitty — a 34-year-old former marketer turned investor named Keith Gill — has become a folk hero.
The online forum on Reddit where he posts, called WallStreetBets, grew from 2.3 million members to nearly 7.7 million members in the past week.
He’s inspired tens of thousands of retail traders to buy heavily shorted stocks in an attempt to “stick it to the man.”
That’s because some of the world’s biggest hedge funds are on the other side of these trades in stocks such as AMC, BlackBerry and Bed Bath & Beyond.
Despite their weak fundamentals, all of these stocks surged higher last week.
Here’s what happened: The hedge funds borrowed stock they don’t own and sold it, hoping that the price would drop and they could buy the shares back at a better price. This is what’s known as “shorting” a stock.
Strong buying pressure from retail traders in heavily shorted companies’ stocks and options led to sharp rallies called “short squeezes.” The hedge funds, fearful of losing too much money, were forced to cover their short positions — that is, buy back the shares they sold — at higher prices.
These squeezes led to massive losses for hedge funds — including a 53% loss for Melvin Capital, a $12 billion hedge fund caught in a GameStop short position.
This chaotic market action isn’t only impacting heavily shorted stocks. It’s also had a ripple effect across the entire market.
The Short/Long Strategy
A hedge fund is different from a mutual fund in that it holds both long and short positions, whereas a mutual fund is typically “long only.”
Most hedge funds deploy a long/short strategy, in which they sell short (bet against) slow-growing companies and buy fast growers.
For instance, a short position in Macy’s would be paired with a long position in Amazon.com. That’s a bet that Amazon is stealing apparel market share from Macy’s.
Or the short sale of an oil and gas company paired with the purchase of a renewable energy stock.
Here’s the problem: If the shorts start rapidly moving up and the hedge funds start losing too much money, they’re forced to both buy back the short stock and sell their longs.
This is a process called “degrossing,” where hedge funds reduce their gross market position.
It’s one of the main reasons the S&P 500 Index was down almost 4% last week, as hedge funds reversed course by covering their shorts and selling their longs.
Are We Looking at a Stock Market Bottom?
Goldman Sachs estimates that last week was the largest hedge fund degrossing since February 2009, with long positions sold and shorts covered in every sector.
Keep in mind, that was the bottom of the 2007 to 2009 stock market crash.
For some perspective, the past three degrossing periods happened in the fourth quarter of 2018, September 2019 and March 2020 … all significant buying opportunities for investors.
Even though the market looks volatile right now and we could see a few tremors after last week’s earthquake, these periods of degrossing are indicative of bottoms, not tops.
If you want to learn more about options — and how Roaring Kitty turned $50,000 into $50 million — please check out my colleague Michael Carr’s upcoming free webinar on options trading.
We’ll have more info about it for you later this week in Smart Profits Daily.
Editor, Automatic Fortunes