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Summary
- Melvin Capital lost 30 per cent of its AUM or US$3.75 billion to an army of retail traders.
- Melvin Capital went on creating a heavy short position in GameStop stock, which eventually rose over 2300% in a few trading sessions.
- The fund got stuck in a classic short squeeze phenomenon which made it difficult to exit the short position.
There’s a company called GameStop which had made a fortune selling video games from its physical stores in the 2000s. However, this is not 2000s and the physical games business has been completely overshadowed by digital space.
Considering this, some professional investors at a hedge fund called Melvin Capital in the wall street thought the company is as good as dead and went on shorting its stock heavily. But an army of retail traders who connect on a popular blog, Reddit thought the other way and were optimistic about the recent induction of Ryan Cohen on the board to turnaround the company.
In this tussle between Reddit traders and Melvin Capital, the Reddit traders have taken the stock from US$19.95 on 12 January to a mind-boggling high of US$483 yesterday. That’s a massive rise of over 2300% in mere 11 trading session. This rise was enough to blow up the short position of Melvin Capital which eventually lost almost US$3.75 billion.
To put it in perspective, it was 30% of AUM of Melvin Capital which it has lost on a single bet. Later on, it had to bring other financial institutions for a bailout which amounted to US$2.75 billion of capital infusion.
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So how did a bunch of retail traders take down a hedge fund?
To sell the security short, the fund had to borrow it from other investors which it did in a huge quantity. However, as the price started to rise the fund panicked and started squaring off its short position, requiring buying back the shares which eventually generated an equivalent buying force.
The hedge fund's buying force worked as a catalyst and shot up the prices even further, leading to further losses. To put it simple, to cover the short position, buying needs to be done which again increases the price requiring for more buying to exit the remaining short position, leading to more losses.
In technical parlance, this phenomenon is known as a short squeeze which the fund got stuck into and ended up blowing a massive chunk of its capital.
