Rumors fly as WallStreetBets sparks a run on shorts

The balance of power in stock markets has shifted. This week's drama in the shares of GameStop (GME) is one of the best signs yet that the power of retail traders can't be doubted.

Shares of the struggling video game retailer were halted after a 69% rally at one point and finished the day up 51%.

The stock was in a tug-of-war between shortsellers Melvin Capital and Citron Research against an army of small retail accounts at WallStreetBets. Melvin manages $12.5 billion but is reportedly down 15% just three weeks into the year in part due to bets against GameStop.

The Reddit community is growing at a sensational pace with trading memes and posts about sensational gains trading short-dated options.

This episode is a major win for the community, where users were showing off huge gains on $60 call options in GME that expired Friday. They traded as low as $0.03 at the start of trading on Friday and hit a high of $17 -- a 566x return or enough to turn a $200 bet into $113,000.

What makes the community especially seductive are stories of people don't just that and screenshots that show incredible gains:

GME huge gain

Some thoughts on where it all leads:

1) Who would be short anything?

There were rumors during the day that Melvin Capital was bust. Obviously that's a wild exaggeration but it's a warning to everyone, everywhere that it's not time to be short anything, no matter the valuation. There's no limit to how much money you can lose in a short and when so many stocks are going up, why would anyone want to be short anyway?

Citron's now somehow made itself a target and that neutralizes the firms biggest (only?) weapon: generating a negative headline buzz.

2) Watch out for anything with heavy short interest

One of the things that attracted bets on GME was that so many shares were sold short. The equivalent of the entire float was held short and the success of this squeeze marks a new frontier for WallStreetBets. Previous big wins had been in extremely thin securities like Kodak but GME was a $1.25B company at the start of the year. That's certainly Apple but it's significant. Rather than the big name stocks, look for this army of options traders to dabble in securities around that size but have some name recognition. That's the formula.

3) This might just be getting started

Every tale of success is a recruiting tool for new users, who invariably join the army. The subreddit now has 2m users, up from about 400,000 at the start of 2019. The numbers are now climbing rapidly and as they grow, so will the clout and power of its userbase. This chart is a sure bet to go parabolic:

WSB users

Consider that Robinhood as 15m users in the US alone and that CNBC's Jim Cramer is now talking about WallStreetBets daily you can see that this could grow much, much larger.

4) The power of mystique

This was a notable battle because it featured a big hedge fund and a very well-known short seller against WallStreetBets. It's clear who won. I think we're at the point where the mere whisper of a post at WSB is enough to spook shorts.

5) Regulation won't come soon

Pump-and-dump schemes are notoriously tough to stop and the disorganized nature of WSB makes it almost impossible to stop. Something about all of this feels wrong but it's so deep into grey area that I don't see anything stopping it. Probably the only risk is that Reddit itself goes after it. Ultimately I expect some troubles to creep in, especially with the mods. They have too much power and the potential for abuse is too tempting. With all that, bigger problems will emerge but I think it's now entering some kind of golden age for the next 1-3 years. It's going to be wild.

6) This helps the broader market, on the margin

Greed is contagious. This is a good sign that we're in speculative bubble but I think it's still just getting started. The Federal Reserve has pinned rates to zero and margin loans are ultra-cheap and easy to get. There's nothing like the thought of someone turning $200 into $100,000 overnight to make people greedy.