It was a routine regulatory process, the kind that hedge funds must do every three months, where Melvin Capital showed his hand for the first time.
The “Form 13F” lawsuit filed on August 14 last year listed 91 positions he held at the end of the second quarter, including stakes in familiar names from Microsoft and Amazon for Crocs and Domino’s Pizza. In the middle of the list: a seemingly innocuous bet against GameStop, a struggling video game retailer.
The fact that the New York hedge fund thought GameStop’s shares were falling was anything but remarkable – many others were betting the same way. Wall Street analysts had ratings of stock sales and the retailer’s outlook looked bleak when players switched to downloads. But by using the options market for the bet, which forced him to disclose the position, Melvin set himself a target.
A watchful Reddit user named Stonksflyingup was not the only one to identify Melvin’s position, but they may have been the most prescient. In a video posted on October 27 on the WallStreetBets message board – entitled “GME Squeeze and the end of Melvin Capital”, using GameStop’s three-letter stock market symbol – the Redditor used a scene from a TV show Chernobyl portray Melvin as a nuclear reactor that would explode when his bet against GameStop went wrong.
In six months, half of Melvin’s $ 13 billion fund was wiped out.
The narrative of the David and Goliath events, in which retail investors organized on Reddit overwhelmed the short sellers who had bet against GameStop, captured the imagination far beyond Wall Street. For many in the hedge fund industry, however, the story has raised the most prosaic question of why Melvin has been so exposed and why he hasn’t given up on trade before – questions he will ultimately have to answer to his clients.
“I don’t understand why Melvin was there, I just don’t understand,” said a prominent short seller who examined GameStop, but decided not to bet against the company.
GameStop has been a favorite target of short sellers for some time. The proportion of shares lent to support these short positions was between 50 and 100 percent of the company’s total stock in the first half of last year, according to IHS Markit. The shares were traded between $ 3 and $ 6.
“We are very uncomfortable if one of our sellers has a 10 percent short interest rate,” said the short seller. The higher the short interest, the greater the risk, because if everyone ran out of their positions at once, a sudden increase in the demand to buy back the shares would further increase the price – a classic tightening in the sale. “This is the part where retailers got it right, to their credit.”
Melvin declined to comment.
The fact that Melvin was caught in such a tight spot is particularly surprising, given the reputation of Gabe Plotkin, who founded the fund in 2014 after years of working for Steve Cohen at SAC Capital Management. Cohen saw him as one of the best dealers he had ever worked with and invested in Melvin from the start. Plotkin was able to be picky about investor money that he would take and block money for longer than most other equity hedge funds.
At SAC and Melvin, Plotkin was known as a discreet but aggressive trader. He didn’t just focus on short selling and often bet more on rising stock prices. However, he had a reputation for vigorous short positions. Melvin was in charge of two of the top five short positions in Europe last month, for example, as measured by a short interest in a company’s shares, according to data group Breakout Point.
Melvin’s stock in August showed that she had put options for 3.4 million GameStop shares, instruments that increase in value as the shares fall. Buying put options is usually seen as less of a risk than traditional short transactions. Puts give you the right to sell shares at what you expect to be a bargain price, but don’t commit to doing so, limiting losses to the option cost, while losses from shorting can be unlimited. But a 13F provides only partial details from which it is not possible to calculate a fund’s total short exposure, and Wall Street continues to speculate on the full extent of Melvin’s position. It was enough to tilt his hand.
The next quarterly report revealed something else: Plotkin was doubling. Melvin’s options position grew to 5.4 million shares in the third quarter, according to the 13F published on November 16, even though the share price rose 135 percent to $ 10.20.
GameStop’s shares detached from the reality of its business prospects © AP
Posts about Melvin on Reddit have become more frequent as forum traders have declared war on the hedge fund promising to take the shares “to the moon”. GME alongside rocket emojis has become a frequent sight on WallStreetBets and users have referred to GameStop as “the greatest short burn of the century”.
The growing risk of short positions has also not gone unnoticed among professional traders.
Fund managers who specialize in investing in undervalued stocks often look to companies with more short short positions to identify potential candidates, since if they are right and the shares eventually go up, a race for short by short sellers can help to raise the price further and faster.
53%
Melvin Capital losses in January
Senvest, another New York hedge fund, noted the interest sold when it bought GameStop in September, for example, according to an interview its founders gave The Wall Street Journal, which revealed its $ 700 million gain from the actions.
An important aspect of short selling involves closely monitoring turnover in targeted stocks, said Brad Lamensdorf, a long-short hedge fund broker who runs Active Alts.
“All investors need to create some kind of process to monitor the market. The volume precedes the price action, ”he said, and GameStop’s trading history contained signs of strong buyback in November and December.
“When you see this kind of heavy sponsorship and stockpiling, it is a dangerous signal for short sellers,” said Lamensdorf.
As Reddit and other day traders accumulated, longtime short sellers, like Melvin, had to decide which way to go. Those who left their positions before the end of the year, with stocks skyrocketing to $ 20, suffered heavy losses – but not as heavy as those who waited until mid-January, when the founder of Chewy.com joined the board of GameStop promising to bring it into the digital age, after which the stock price has become parabolic.
The temptation to stay on course was obvious, as GameStop’s stock strayed from the reality of its business prospects and would one day fall. But with the level of uncovered interest rising, not decreasing, the risks increased. In the meantime, investors have started trying to get short sellers out of other popular positions as well, such as the AMC movie theater chain, the BlackBerry technology group and others. Many of Melvin’s shorts suffered melee losses.
“The stocks in question are, from a market capitalization perspective, little guys,” said Brian Barish, president of Cambiar Investors. “What Reddit people got right is that this ecology was ready to be disturbed by a sudden increase in trade. Even though GameStop has a very poor long-term viability, shortening so much to express this opinion is very dangerous. “
When Plotkin was forced to abandon his bet against GameStop last week and crystallize his losses, the shares reached $ 483 that day, up 11,000 percent since the second quarter of last year. Melvin received a $ 2.75 billion emergency cash injection from two other hedge funds – $ 750 million from Cohen’s Point72 Asset Management and $ 2 billion from Ken Griffin’s Citadel – to deal with the losses and complete the fund . It had lost 53% of the $ 13 billion it managed in early January over the course of just a month.
Melvin now faces the task of recovering from the disaster, with the industry’s eyes on him, but at least with two powerful endorsements. “I have known Gabe Plotkin since 2006 and he is an exceptional investor and leader,” said Cohen last week, as he doubled the weight of his protégé. Griffin was also public in his praise. “We have great confidence in Gabe and his team.”