Shorting stocks has never been an easy way for a nice person to make a buck. For most of the bull market that followed the 2008 financial crisis, it was an outright nightmare.
But this? This is something else, as swarms of traders crowded in internet chatrooms storm together into long positions of heavily shorted companies. They are calling out — by name — the fund managers they hope to squeeze out of business, while reaping triple-digit short-term returns in the process.
The drama is causing a sudden re-think among the relatively small number of firms that successfully focus on activist shorting, a strategy that involves betting against a company and publishing research reports intended to convince shareholders the stock is overvalued. As Ben Axler of activist short-selling hedge fund Spruce Point Capital put it: “Adapt or die.”
“Risk management is critical during euphoric periods unhinged from fundamentals,” Axler said. “It’s become more critical to understand who’s on the other side of the trade, and what the bull case is. Markets have always been ‘adapt or die,’ and today is no different.”
The growing mobs on Reddit’s WallStreetBets forum and other favored social-media destinations are leaving some serious wounds in the hedge-fund space. Melvin Capital Management started 2021 with a loss of about 30% because of short positions on GameStop Corp. and other companies that went awry. Citron Capital’s Andrew Left, a popular target on Reddit, said on Wednesday his firm closed out of a GameStop short bet “at a loss of 100%.”
Carson Block, who made a name for himself with numerous successful short sales of Chinese companies, said his Muddy Waters Capital “massively reduced” its short positions in recent days, mostly sidestepping the buying frenzy that has burned some peers.
Others claim to have escaped. Gabriel Grego, chief investment officer at Quintessential Capital Management, says the firm wasn’t affected by any of the recent squeezes. Still, it’s putting new short campaigns on hold.
Next Target
“It’s given us a lot of room for thought because maybe the next target that we choose is going to be the reason investors pile on it like they did with GameStop or AMC,” he said. Until the situation stabilizes or “markets go back to sanity,” the firm is looking for new opportunities outside of the U.S. where this type of dynamic has not materialized.
Another option under consideration is to find new ways to be an activist such as betting on higher volatility of a stock rather than selling it short.
“If the markets act rationally, the stock price should drop,” Grego said. “If they act irrationally, they would just massively rip, so it would make sense to go long volatility rather than taking a simple short.”
An index of short-selling hedge funds is under pressure
The tactics being promoted on the message boards often focus on forcing both short-sellers and equity-options dealers to buy shares and pump up prices way beyond reasonable values. Viewed one way, the Reddit mobs may serve as something like a new sheriff in town walking the short-seller beat.
‘Smash and Grab’ Over
The days of “smash-and-grab” shorting are over, according to veteran bear Marc Cohodes, referring to investors who release a critical research report and then quickly cover their positions following an initial share price drop — or those who piggyback on others’ work and crowd into bearish positions. More discipline will be required, he says.
“The last thing the referee tells you when you’re in a boxing match before they ring a bell is ‘protect yourself at all times,’” he said. “And these big hedge funds who’ve been short and over-concentrated in these names have been arrogant, pompous and didn’t realize they were overstretched.”
The big lessons of the last week are pretty simple, according to Fraser Perring, founder of Viceroy Research: “If you go short, make sure you have a position that in some way preserves some capital if the trade goes against you in the short term. If the cost of that strategy is too high, the risk isn’t worth it. Price discovery is officially suspended.”