Game Theory and Hedge Funds
Game Stonks — The Hedge Fund Chaos
The Hedge Fund Chaos Explained via The Chicken Game Analogy
You have probably already heard about r/WallStreetBets and the GameStop stocks unless, of course, you have been living under a rock for the past few weeks. But the matter isn’t as simple as a sequence of events but involves many strategies, and since we are covering the issue, Game Theory.
Stock Market Jargon:
Before we move on, let’s understand how stocks work. What makes their price go up and down like a roller coaster.
Stock prices, just like any commodity, are affected by fundamental concepts of supply and demand. In simple terms, the higher the supply of a stock, the lower its price, and vice versa. Similarly, the higher the demand for the stock, the higher the cost.
Of course, conventionally, people buy stocks at a particular value and hope that the stock price would rise in the stock market. Once this stock price rises, these people can sell their stocks and earn profits. Simple.
Now, in the real world, not all stock prices go up. Some of them go down as well. When you have a clue that a specific stock might go down, you short a stock.
Shorting:
When shorting, you ask your broker to sell a stock that you do not own. So, your broker borrows a stock and sells it for you. Now, you wait for the time when the stock price falls. Once this happens, you can purchase the same stock for cheaper than what you sold them for and return it to the original owner, thus making a profit in the process.
For example, if there is a stock X that is being sold today for 500. You ask your broker to short it. He shorts five stocks, and you get 2500 rupees. After a few days, the price falls to 300. Now, since you sold stocks that you did not own, you have to repurchase them to square off your position in the market. So, you buy five stocks, and that will cost you 1500 rupees. In the end, you earn a profit of 1000 rupees minus the brokerage.
We know it sounds complicated, and to an extent, it is! Shorting is, by definition, much riskier and intricate than regular investments. In traditional investments, one waits for the prices to rise, but in the worst case, the price plummets to zero, and you lose all the money you put in. On the other hand, when one shorts a stock, in the worst case, prices skyrocket. But the issue is, unlike a drop in prices, a rise in the cost of a stock doesn’t have an upper limit, so theoretically, your losses can rise to infinity.
Short-Squeeze:
At this point, say you have shorted a stock. Having predicted that the stock prices will fall, you wait for the prediction to come true when you can buy-back the stocks and close your position.
Now, if someone comes along and starts buying and holding these stocks, thus increasing demand and reducing supply, they can jump the stock-prices upwards by a certain degree. Adding to that, everyone who had shorted the same stock needs to buy-back these stocks to close their positions and unwillingly contribute to the demand increase.
And just like that, all of a sudden, your prediction that the prices would fall has been trashed. As time ticks, you are under increasing pressure to close your position in the market and are left playing a Chicken Game in deciding when to square off your position. Anyway, we’ll get back to that soon! But before that, let’s meet the players of this Game of Chicken.
Player 1: The Hedge Funds
Hedge Funds, like everyone, want to reduce risk and maximize profits when investing in stocks. The only difference is that they are so huge and wealthy that they can manage reducing risk to a large extent unless, of course, a group of people decides to do something.
*Enter r/WallStreetBets*
Player 2: r/WallStreetBets:
Of course, good ol’ Reddit is involved. So, on this particular subreddit, a bunch of people discussed stocks and trading in general. The people here noticed the level at which certain hedge funds were shorting some retro companies’ stocks, and most notably, GameStop.
Now, will a group of well-knit people, via the internet, of course, let the big bullies of hedge funds run GameStop stocks to the ground? Of course not! GameStop was a sinking ship, considering the pandemic and people’s growing inclination towards digital libraries over physical copies of games. However, it is essential to note that GameStop has a history. People have an emotional connection with the gaming haven from their childhood. The hedge funds ‘Predicting a drop in prices of GameStop stock’ or, in other words, gaslighting GameStop stock by using their social capital for their interests did not go down well with most people.
Objectively, it makes no sense to go long in stocks for a sinking company, but we’ve said it before, and we’ll say it again, not all decisions are made based on logic. Of course, due to the over-shorting of the stocks, it may have made logical sense too!
And so begins the Game of Chicken…
Since shorting is a very virtual activity, you are selling stocks that you never actually had. And in the case of GameStop, more stocks were shorted than existed in the first place.
At this point, our subreddit, r/WSB, indulge in something called Short-Squeezing.
The subreddit and the people involved ended up buying huge amounts of GameStop stocks and holding them. The demand for the stock was rising as people continued to buy and hold on to the stocks. All while the hedge funds had already shorted the same, and they managed to increase the stock more than 80 fold.
This rise in the stock price meant that Hedge Funds lost close to 5 billion dollars since their prediction that the costs would drop dropped right down to the bottom of the trash can, and so began the Game of Chicken.
The Game of Chicken
Simply put, the Game of Chicken is based on a classic example of two people driving a car straight at each other. The question remains, who will chicken out first?
In this case, there are four outcomes for our two players (say X and Y).
First: Both the players swerve to avoid a crash. In this case, both of them don’t gain anything but don’t lose anything either. They both end up ‘chickening out’.
Second/Third: One of the two players decides to chicken out and swerve. In this case, the one that doesn’t swerve gains bragging rights, albeit for a foolish dare, while the other loses the same by being too chicken for the game.
Fourth: Neither of the players are too chicken for the game and, in their blatant chase of thrill, end up colliding and probably dying.
Now, back to our story.
At this point, the hedge funds had to make a choice, to accept defeat from a group of nobodies on a subreddit and close their position while incurring heavy losses, or hold on, hoping that the people will chicken out before the pay-off, and the stock prices will drop again. Swerve, or go straight ahead. Of course, there is an extra factor in closing their position in the market before time.
On the other side, the people have a similar choice to make, do they hold on and risk losing, or bail out and let the hedge funds enjoy a new lease of life. Again, swerve or go straight?
Either way, the entire fiasco has left GameStop as the winner, as the once-struggling company’s prospects have opened up. Moreover, one might be so bold as to claim that the deep dark realms of the stock market have been, to an extent, democratized by the entire chain of events.
TL;DR, a page on Reddit took on Wall Street’s highly paid executives and managed to win…
….or have they?
Thanks to Manu Singh for his valuable input which laid the foundations for this piece.
