Melvin Capital, GameStop and the road to disaster

It was a routine regulatory filing, the kind hedge funds must make every three months, where Melvin Capital first showed its hand.

The “Form 13F” filing that landed on August 14 last year listed 91 positions it held at the end of the second quarter, including shareholdings in household names from Microsoft and Amazon to Crocs and Domino’s Pizza. Halfway down the list: an apparently innocuous bet against GameStop, a struggling video game retailer.

That the New York hedge fund should think GameStop’s shares were going lower was hardly remarkable — many others were betting the same way. Wall Street analysts had sell ratings on the stock and the retailer’s prospects looked grim as gamers switched to downloads. But by using the options market for the bet, which forced it to disclose the position, Melvin had put a target on itself.

An eagled-eyed Reddit user called Stonksflyingup was not the only one to spot Melvin’s position, but they might have been the most prescient. In an October 27 video posted on the WallStreetBets message board — titled “GME Squeeze and the Demise of Melvin Capital”, using GameStop’s three-letter stock market ticker — the Redditor used a scene from TV show Chernobyl to portray Melvin as a nuclear reactor that would blow up when its bet against GameStop went wrong.

Within six months, half of Melvin’s $13bn fund had been wiped out.

The David-and-Goliath narrative of the events, in which retail investors organised on Reddit overwhelmed the short-sellers who had bet against GameStop, has captured the imagination far beyond Wall Street. To many in the hedge fund industry, however, the tale has raised the more prosaic question of why Melvin left itself so exposed and why it didn’t reverse out of the trade earlier — questions it will ultimately have to answer to its clients. 

“I don’t get why Melvin were there, I just don’t get it,” said one prominent short seller who had looked at GameStop but decided not to bet against the company.

GameStop had been a favourite target of short-sellers for some time. The proportion of shares borrowed to back those short positions had been between 50 and 100 per cent of the company’s total stock over the first half of last year, according to IHS Markit. The shares traded between $3 and $6.

“We get really uncomfortable if one of our shorts has a 10 per cent short interest ratio,” the short-seller said. The higher the short interest, the higher the risk, since if everyone rushed to exit their positions at once, a sudden surge in demand to buy back stock would push the price up further — a classic short squeeze. “That’s the part where the retail people got it right, to their credit.”

Melvin declined to comment.

Even if GameStop has very poor long-term viability, shorting it this much to express this opinion is just too damn dangerous

That Melvin was caught in such a squeeze is particularly surprising given the reputation of Gabe Plotkin, who founded the fund in 2014 after years working for Steve Cohen at SAC Capital Management. Cohen viewed him as one of the best traders he had ever worked with, and put money into Melvin early on. Plotkin was able to be picky about which investors’ cash he took, and would lock up money for longer than most other equity hedge funds.

At SAC and at Melvin, Plotkin was known as a low-profile but aggressive trader. He did not focus solely on short selling, and often ran bigger bets on rising share prices. Nevertheless, he had a reputation for punchy short positions. Melvin was running two of the five biggest short positions in Europe last month, for example, as measured by short interest in a company’s stock, according to data group Breakout Point.

Melvin’s August filing showed it owned put options for 3.4m GameStop shares, instruments that rise in value as the stock goes down. Buying puts is typically seen as lower risk than traditional shorting. Puts give you the right to sell shares at what you hope is an advantageous price, but do not commit you to doing so, capping losses at the cost of the option, whereas 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 about the full extent of Melvin’s position. It was enough to tip its hand.

The next quarterly filing revealed something else: Plotkin was doubling down. Melvin’s options position had grown to 5.4m shares over the third quarter, according to the 13F published on November 16, even as the share price had risen by 135 per cent, to $10.20.

The posts about Melvin on Reddit became more frequent as traders on the forum declared war on the hedge fund by promising to drive the shares “to the moon”. GME next to rocket emojis became a frequent sight on WallStreetBets and users referred to GameStop as “the real greatest short burn of the century”.

The growing riskiness of the short positions had also not gone unnoticed among professional traders.

Fund managers who specialise in investing in undervalued stocks often look at the most heavily shorted companies to identify potential candidates, since if they are right and the stock eventually goes up, a rush to the exits by the short-sellers can help drive the price up further and faster.

53%


Melvin Capital’s losses in January

Senvest, another New York hedge fund, noted the short interest when it bought into GameStop in September, for example, according to an interview its founders gave to The Wall Street Journal, which revealed their $700m gain on the stock.

An important aspect of short selling involves closely monitoring trading volume in targeted stocks, said Brad Lamensdorf, a long-short hedge fund trader who runs Active Alts. 

“All investors need to create some kind of process to monitor the market. Volume precedes price action,” he said, and the trading history of GameStop contained signs of heavy buying back in November and December.

“When you see that kind of heavy sponsorship and accumulation of a stock, it represents a dangerous signal for short sellers,” said Lamensdorf.

As Reddit day traders and others piled in, longtime short sellers like Melvin had to decide which way to jump. Those who got out their positions before the end of the year, as the stock soared towards $20, suffered heavy losses — but not as heavy as those who waited until the middle of January, when the founder of Chewy.com joined GameStop’s board promising to bring it into the digital era, after which the share price went parabolic. 

The temptation to stay the course was obvious, since GameStop shares had become detached from the reality of its business prospects and would one day tumble. But with the level of short interest going up, not down, the risks were mounting. Meanwhile, investors started trying to squeeze short sellers out of other popular positions, too, such as the cinema chain AMC, the tech group BlackBerry and more. Many of Melvin’s shorts sustained losses in the melee.

“The stocks in question are, from a market cap perspective, little guys,” said Brian Barish, president of Cambiar Investors. “What the Reddit crowd have gotten right is that this ecology was ripe for being upset by a sudden surge in trading. Even if GameStop has very poor long-term viability, shorting it this much to express this opinion is just too damn dangerous.”

When Plotkin was forced to exit his bet against GameStop last week and crystallise its losses, the shares peaked at $483 on the day, a rise of 11,000 per cent since the second quarter of last year. Melvin took an emergency cash injection of $2.75bn from two other hedge funds — $750m from Cohen’s Point72 Asset Management and $2bn from Ken Griffin’s Citadel — to deal with the losses and top up the fund. It had lost 53 per cent of the $13bn it was managing at the start of January over the course of just one month.

Melvin is now faced with the task of picking itself up from the debacle, with the eyes of the industry upon it but at least with two powerful endorsements. “I’ve known Gabe Plotkin since 2006 and he is an exceptional investor and leader,” Cohen said last week as he doubled down on his protégé. Griffin, too, was public in his praise. “We have great confidence in Gabe and his team.”