About three months ago, the investing world was left reeling after retail investors proved they can beat Wall Street at its own game.

Reddit group “r/Wallstreetbets” (aka WSB)--a longstanding subreddit channel created nearly a decade ago where more than 4 million Reddit users discuss highly speculative trading strategies and ideas--engaged in a crowdsourced pump-and-dump scheme that created massive volatility in the stock markets by buying heavily shorted stocks such as GameStop Inc. (NYSE:GME),  AMC Entertainment Holdings (NYSE:AMC), and BlackBerry Inc. (NYSE:BB), among others. The massive buying wave created large short squeezes as hedge funds betting against these stocks rushed to cover their positions and cut losses after GME skyrocketed an unfathomable 1,500% in the space of a few days; AMC saw its share price triple while BB jumped 460% before they came crashing to the ground after popular zero-fee trading app Robinhood blocked trading activity.

Many analysts suspected the SEC would quickly act to nip this emerging trend in the bud while Nasdaq promised it would flag any suspicious trading activity.

But it now appears that this is not the last we will be seeing of the little guy pummeling the big guy in the stock markets.

A basket of stocks heavily favored by smaller investors has been outperforming the broader market since March of last year, according to Vanda Research. This group, consisting of tech behemoths like Apple Inc. (NASDAQ:AAPL) and Tesla Inc. (NASDAQ:TSLA) alongside electric-vehicle maker NIO Inc. (NYSE:NIO) and digital-payments company Square Inc. (NYSE:SQ), has gained 68% since the beginning of March 2020 through Monday, comfortably outpacing the S&P 500’s roughly 36% climb.

Interestingly, meme stocks popular with retail investors have been on a tear, again: AMC is up 140% over the past 30 days, Hertz Global Holdings, Inc.(OTCPK:HTZGQ) has gained 181% while GME has rallied 24% over the timeframe.

Other meme stocks that were banned on Robinhood after the February short squeeze have also been making big moves: Koss Corp. (NASDAQ:KOSS), Naked Brand Group (NASDAQ:NKD), Sundial Growers Inc. (NASDAQ:SNDL), and Trivago Inc. (NASDAQ:TRVG) have all outpaced the market by wide margins this year.

Source: CNN Money

Naked shorts

Whereas the current wave of buying meme stocks is not quite as pronounced as the last one in February, it has once again brought into focus a thorny problem in today’s fast-moving markets: Naked short selling.

SEC data shows about $359 million worth of GME shares were caught in limbo when the stock hit a crescendo.

No less than 1 million GME shares were deemed failed-to-deliver on January 28 either due to buyers lacking cash to complete purchases or sellers not having the shares to settle trades.

This appears to reinforce an unproven but growing theory that hedge funds might have been involved in naked short-selling of GME and other meme stocks.

“Fails-to-deliver can occur for a number of reasons on both long and short sales,” reads a disclaimer on the SEC website. “Therefore, fails-to-deliver are not necessarily the result of short selling, and are not evidence of abusive short selling or ‘naked’ short selling.”

Failures to deliver can result in fines, losses as well as reputational harm, and in rare circumstances, there’s also a risk they could lead to a reduction of market liquidity.

GME and Li Auto stocks featured heavily in SEC’s fails-to-deliver list dominated by exchange-traded funds.

Market rigging

The SEC defines manipulation as intentional conduct with the objective to deceive investors by artificially affecting the market for a security, including creating a false or deceptive picture of the demand for a security or commodity as well as rigging quotes, prices, or trades. 

The commodity market is no stranger to massive pump-and-dump schemes.

Perhaps one of the most high-profile is the Hunt Brothers and Silver Thursday fiasco of the 1970s.

When oil tycoon H.L. Hunt passed away in 1974, two of his sons, Herbert and Nelson, took their inheritance and invested in a way their father would never have imagined--by betting on silver, big-time. The Hunt brothers were convinced that massive inflation would soon decimate the value of any investments denominated in paper currency and make silver a preferred safe haven in the ilk of its more illustrious cousin, gold.

The brothers began to buy up physical silver as well as futures contracts, but chose to take physical delivery of the silver instead of closing out contracts as is the norm. They borrowed heavily to finance their bets, using the revered Hunt name to obtain ever-growing lines of credit including from Saudi investors. The brothers built massive stockpiles of silver and a position worth around $4.5 billion, leading to prices surging to $50 per ounce thanks to the famous short squeeze.

At this juncture, Federal commodities regulators became concerned by what they saw as a clear attempt at manipulating the nation's silver reserves. Consequently, they introduced special rules barring long contracts from being written or sold for silver futures. In other words, longs were effectively frozen while the shorts were free to pile in. The Hunts could no longer access cheap credit and missed a margin call on March 27, 1980, leading to Silver Thursday with silver prices crashing spectacularly.

When it comes to heavily traded commodities like oil, there have been several well-documented cases of market manipulation by traders, but nothing on the scale of the Hunt Brothers--at least not resulting in the same kind of damage.

A decade ago, two well-known traders and two trading firms owned by Norwegian billionaire John Fredriksen were indicted for one of the biggest ever crackdowns on oil price manipulation. The Commodity Futures Trading Commission (CFTC) ruled that traders James Dyer of Oklahoma's Parnon Energy, and Nick Wildgoose of Europe-based Arcadia Energy, amassed large physical positions at a key U.S. trading hub in a bid to create the impression of tight supplies and goose prices. The traders would then dump those “lost” barrels back into the market, crashing prices and profiting from short-sale positions held in futures markets. In the end, the traders were able to pocket ~$50 million in ill-gotten gains which Bart Chilton, commissioner of the Commodity Futures Trading Commission (CFTC), termed as a ‘‘very big deal.’’ Still, it does not compare to the nearly two-thirds of silver stocks that the Hunt Brothers held at the height of the silver scandal.

Generally speaking, very large markets like oil’s and gold’s are hard to manipulate by single traders, market makers like Goldman Sachs, central banks, corporations--or WSB-- and the aphorism that low prices cure low prices tends to ring true. Any attempts to systematically suppress oil prices would be counterproductive because they would trigger upward pressure on prices.

The same applies to naked short selling, or the sale of oil that is not currently owned by the seller (usually borrowed) and the subsequent repurchase of the oil in a bid to take advantage of the price decline and enable the oil to be repurchased at a lower price.

If short sellers were left uncovered on platforms such as ICE or NYMEX, a huge ‘short squeeze’ would sooner or later unravel and any manipulation using naked shorts would be short-lived.  Naked short selling has become much more sophisticated though, with short-sellers sometimes managing to stay naked for months on end as James Stafford, founder and CEO of Oilprice.com, has reported. Mr. Stafford says that traders have become adept at using techniques such as “spoofing” and “layering” to avoid attention from regulatory authorities. Spoofing, as the name suggests, involves short sellers creating fake selling pressure on their targeted stocks to drive prices lower. They accomplish this by submitting fake offerings in “layers” at different prices to create a mirage.

But eventually, oil traders who attempt to game the market would eventually have to contend with the all-powerful forces of supply and demand as Saudi Energy Minister Prince Abdulaziz bin Salman warned last year:

“We will never leave this market unattended. I want the guys in the trading floors to be as jumpy as possible. I’m going to make sure whoever gambles on this market will be ouching like hell.”

As for Reddit’s WSB, the group now suffers from a more prosaic problem: The lack of collective unity needed to band together on an anonymous platform. After Robinhood moved quickly to limit trading on GME, AMC, and other target stocks, WSB traders have become less trusting and suspicious of each other or tend to bail on a stock too early, thus limiting the group’s effectiveness.

By Michael Kern for Oilprice.com