Hedge fund titans squeezed out of their shorts

BY Chris Andreou

|February 10, 2021

Did a hoard of retail traders squeeze the hedge fund giants out of their short trades in January 2021? This is what it certainly looks like. At the time of writing this, the news is freshly out but the magnitude of the recent developments is such that it will change the hedge fund industry and maybe even the laws regulating trading, leverages and information sharing for years to come. These are historic times and very likely milestones that we will, later on, look back to. At least one movie is already planned and several trading books, I’m sure, will refer back to January 2021 and the lessons learnt. Suddenly there is a whole new set of risks the hedge funds have to prepare for and manage. The fact that small traders can team together via social media and drive up the prices of stocks and even commodities as they buy in a concerted manner makes the future hedge fund risk managers think twice before continuing implementing their short trading strategies in a business as usual manner.

The real big names in the hedge fund industry have taken some unusual hits over the first few weeks of the year 2021. Such iconic names as Renaissance Technologies and Pershing Square have had significant and unusual losses with Renaissance’s institutional equities fund losing 9.5% in January and their institutional diversified alpha dropping 5.4%. At the same time, Bill Ackman’s Pershing Square was down 3.2%. With Nasdaq ending January flat, S&P 500 and Dow Jones Industrial Average less than 2% negative and Russell 2000 making 4.5% it is remarkable that these best of the best in the hedge fund industry managed to lose so much. To give an idea on the size of these operators Renaissance Technologies managed almost $166 billion at the beginning of 2021 and the assets under management (AUM) with Pershing Square Capital Management in November 2020 were $13.1 billion.

Now, these operators, being hedge funds, should be able to create positive returns in all kinds of markets. As hedge funds are not required to reveal their strategies and or positions (some exceptions apply) we don’t know the details related to these losses. However, due to the fact that they coincide with the Reddit debacle, it seems likely that short squeezes in stocks like GME and AMC have forced losses on them.

Without knowing any specifics it looks like these funds have had too high trust on computerised trading algorithms that feed off of historical volatility models. When something surprising happens these models just can’t handle the trading any longer. Another alternative is that traders might have been instructed to double down with the expectation that the stocks like GME and AMC will eventually reverse their rallies and move down. Yes, the bull runs eventually reversed and these stocks came down, but only after billions of dollars were lost by those shorted at (too) low prices and were then forced to exit when stocks went ballistic! Perhaps good old momentum trading should be appreciated a little more. Little less reliance on computers and more human intelligence combined with strict risk limits seems in order.

There is actually a way to avoid such losses from core positions. It is called: Trading against your core positions. It requires that funds have thought this through beforehand (which I am sure all of them are doing now!) and integrate experienced price action traders in their teams. These traders could employ strategies that are non-correlated to the core positions. In this case, shorts in GME and AMC for instance.

What do I mean by this? Let me explain. When a hedge fund takes a short position it tends to be at least a medium-term and maybe even a long-term position. If the fund manager and his/her analysis team believe in their original thesis about the stock they are willing to a) hold to their short even if the price goes against them and b) add to their short at a higher price level. In other words, sometimes these short positions are fundamental plays based on the fund manager’s view on the target company’s business. Thus the fund theoretically exposes itself to unlimited upside risk. By employing skilled price action traders that are allowed to trade against the core (short) positions risks can be significantly reduced. With momentum strategies, professional short-term traders can create positive cash flow during the time the fund is positioned short. Provided there are no significant liquidity restraints of course. And, as we are talking about short-term long trades the negative impact on the original short position is minimal. The net impact of these in-and-out long trades is zero.

You and I can apply the same method when holding a position in a stock, commodity or Forex CFD. It doesn’t matter if we are long or short, we can always trade against our own positions. Especially when the core position is meant to stay on for several days. For example, if you are short in EURUSD and believe the pair is likely to move lower in the coming few days but then see that there is upside momentum building up (the pair is about to rally higher). This is when you can either close the short position or take a long trade against it. If you want to keep the original short position but want to also benefit from the rally about to take place, with TIOmarkets you can do so at a very low cost. Just open a VIP Black account with us and you can trade without per trade transaction or monthly fees.

TIOmarkets is committed to helping you to learn and develop yourself as a trader. This is why we have free webinars and other education material at TIOmarkets.com/analysis. Go to TIOmarkets.com/webinars to register for our next Live Trading Strategy Workshop for free. I will be there to teach you and share from my 20+ years of experience in markets and trading. Also, if you haven’t yet done so open a VIP Black account with TIOmarkets. You will get a great trading environment with tight spreads and no monthly subscription or per-trade fees. Register here: TIOmarkets.com

Trade Safe,

Janne Muta
Chief Market Analyst

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