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Some Advice for the GameStop "Rebellion"

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The story of the meteoric rise of the shares of GameStop (GME - Free Report) is actually a number of stories. It started as an informal group of traders communicating in online message boards – most notably Reddit’s Wallstreetbets/ forum – and trading in unison. Those traders collectively determined that shares of GameStop had such high short interest that if they began buying those shares and call options in a coordinated manner, they would force the funds who held short positions to cover their positions at higher prices.

It was a fairly classic “short-squeeze” and it worked.

GameStop started 2021 trading at $17.25/share. By January 15th, it had exactly doubled to $35.50/share after the news that week that Chewy (CHWY - Free Report) founder Ryan Cohen had amassed a nearly 13% stake in the company and would be joining the board of directors - ostensibly to guide the company’s transition from strip mall brick-and-mortar retailer to online presence.

It was a "comeback" story.

On Friday January 22nd, GameStop closed at $65/share and the short squeeze had become a rout, inflicting severe losses on at least two well-known, short-selling hedge funds.

That’s also when even more stories began to develop. It was no longer simply about exploiting an inefficiency and making a profit form it. The tone of the online messages among the GameStop faithful shifted significantly toward enthusiasm about inflicting pain on hedge funds and other professional investors.

“Little Guys Take on the Big Guys and Win!” Is an easy headline to love. So are stories about people using profits from the trade to pay health care bills or pay off student loans. The "steal from the rich and give to the poor" aspect of the trade added to its popular appeal.

The threats of violence against opposing traders and journalists makes the feel-good story feel considerably less good.

The desire to make money by risking your capital in the markets and having your thesis proven correct is not only understandable, it’s necessary. The role of speculators (including short-sellers) is fundamental to the healthy functioning of financial markets.

In addition, many of the Wallstreetbets traders have expressed the notion that they don’t care if they lose money, as long as they have caused pain to the Wall Street “elite.” They’re trading to express their anger rather than amass profit. That’s ridiculous.

(What’s also ridiculous is that last night, Apple (AAPL - Free Report) reported the results of a very successful quarter that included $111 billion in revenues and almost no one is paying attention.  The worst part about the GameStop episode for those who have no interest in participating may be the distraction it’s causing.)

Here’s my advice:

The best traders want to make the most money possible while taking the least risk possible.

Period.

Trying to exact revenge from the faceless counterparties that you believe hhave somehow wronged you in the past is an inefficient endeavor - and one that’s very likely to end up with you losing money. It’s human nature to engage in Schadenfreude from time to time, but it’s a fundamentally non-constructive activity. Trading with the objective of hurting another market participant interferes with your own objectivity.

Your goal should not be to “beat the market” or to beat any specific party, it should be to put as much cash as possible in your own pocket. If you see an opportunity to squeeze someone else who put themselves in a disadvantaged position, by all means take it. Those are the situations that great trades are made of. But do it because you see the opportunity to be disproportionally rewarded for the risk you take. Do it because you want the money. Don’t do it because you “hate” the other guys or are jealous of their previous success.

One of the great trades of our time was George Soros versus the Bank of England in 1992. (If you don’t know the story, look it up – it’s fascinating.) In a nutshell, Soros correctly surmised that Great Britain didn’t have the resources to continue supporting the Pound and he successfully shorted it and made over a billion dollars in the process.

Soros didn’t hate England. He didn’t want to “stick it to them” or intentionally cause harm to British Central Bankers or ordinary citizens.

He just wanted the money!

There’s another aspect to the GameStop trade that I’d like to address. It’s the concept of patience in investing. I fully understand that when you’re 25 years old, you want to get wealthy now. Making a huge score on a single trade is an extremely attractive concept. Unfortunately, it’s also not very realistic.

Ken Griffin of Citadel was just like you once. Citadel was literally founded in a college dormitory room. Griffin recognized that the market often wasn’t correctly pricing convertible debt efficiently and that he could make small but consistent arbitrage profits by trading mispriced convertibles against plain-vanilla bonds and listed options. He built on his early successes and eventually built one of the most influential money-management and market-making firms the world has ever seen.

There was no single trade that made Citadel what it is; it was millions and millions of small trades in which they had a real edge. Griffin didn’t set out to prove a point or oppress the masses. He simply rooted out all of the profit opportunities he could and capitalized on them.

Most successful fund managers won’t risk more than 5% of AUM on a single trade. There’s no “all-in” button on their trading terminals. 5% is what they throw at the ideas they’re most sure about! The lay-ups might get 5% - everything else gets much less.

This morning I made a spreadsheet to illustrate how much money a 25 year-old investor might amass in an ordinary tax-advantaged retirement account like an IRA or 401K. Assume that a young investor started participating in the markets at the beginning of 2020, putting $500 per bi-monthly paycheck into a retirement account and buying a mutual fund or ETF that mirrors the S&P 500.

At the end of the year, that person would have contributed a total of $12,000. On December 31st, the account value would have grown to $14,191, plus $163 in cash dividends. That $14,353 represents a 19.6% return on the investment. That’s a sensational return.

If you’re saying to yourself, “Sure it’s a great percentage return, but who cares about 2,300 bucks? My rent is more than that,” read on…

Let’s say that our trader stopped investing altogether right now and simply let the balance grow until she retired at age 65. Assuming the long-term average return of the S&P of about 8%/year and another 2% in cash dividends, that account will have grown to $688,493.

If she instead continued to contribute the same $500/check over the course of the next 39 years and realized that same 8% + 2% return, that retirement account would be worth more than $5.8 million dollars. Plus she didn't pay a dime in taxes on those gains and gets to decide how she wants to withdraw the proceeds to maximize tax savings.

Keep in mind that having a stable plan for building wealth over decades doesn’t preclude you from participating in the financial markets in a more speculative way if and when you can afford it. I truly believe that well-informed investors can (and do) make excess returns by carefully picking stocks as well as executing a sensible options strategy to mitigate risk and add income.

You’re already here, so I’m probably preaching to the choir, but imagine the wealth that could be generated if you combined targeted investments in stocks with a Zacks Rank #1 (Strong Buy) with the passive index strategy above.

When you look around and see people who seem to have much greater wealth than you do, there’s an excellent chance that they’ve been availing themselves of the opportunity to reap the rewards of compound wealth building in the financial markets over a long period of time.

There might be a handful that have had one lucky break and a single great trade, but they’ll be the very rare exception rather than the rule. There will also be some people who won a lottery jackpot, but that certainly shouldn’t encourage you to buy lottery tickets.

It’s a well-worn story in the financial markets that traders who make everything they have on a single trade almost always give it all back – and sometimes much more – as they chase additional profits and simultaneously discount the role that luck played in their windfall.

I don’t have much of an opinion on the social justice aspect of the GameStop trade. As an observer of market dynamics behavior, I find the whole episode fascinating and I truly don’t care who ultimately “wins.” (Though I do hope that the episode doesn’t sour any investors on the concept of owning equities in general.)

I don’t have a dog in this fight because my focus is primarily on finding profit opportunities for myself and for those investors who find my knowledge and advice valuable. If you want to try to trade GameStop stock or options – or any of the other heavily shorted stocks that have also become popular on the internet forums – go ahead, but please be careful and risk only what you can afford to lose.

Most importantly, don’t let the insane volatility cause you to take your eyes off of the prize. Lean on the concept of sensible, long-term investing to achieve your financial goals.

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