This week, the global stock market went down the Reddit hole.

A growing army of day traders has been a feature of the recovery in stocks since the sell-off last March, as a mixture of lockdowns, low interest rates and cancelled sporting competitions encouraged more and more everyday investors to try their hand at the equity market. This has accelerated since the start of 2021, as the Reddit message board, and its fast-expanding r/WallStreetBets community, have managed to channel the energy to a handful of previously unloved stocks.

The result has been a turbulent week for those shares at the centre of the action, which has spread to individual stocks around the world. Wild bouts of trading have triggered stock-exchange trading curbs and restrictions from brokers on what customers are allowed to buy.

Overall volatility in the stock market has increased, and people far beyond the finance industry have been transfixed by the battle between Wall Street and the have-a-go individual investor.

How did we get here?

For months, some Reddit users — led by one going by the moniker DeepFuckingValue — have made the case for investing in GameStop, a video game retailer attempting a turnround in the face of stiff online competition. The board appointment of Chewy founder Ryan Cohen gave the bulls their first big fillip in early January. But the investment case they presented was boosted by a major technical issue: the possibility to profit by pushing against Melvin Capital and other hedge funds that had bet heavily that GameStop’s share price would fall.

Such hedge funds make money from short-selling a company’s shares — in effect betting that the stock price will go lower. The investment firm borrows the company’s shares and sells them, in the hope of buying them back at a reduced price and returning them, while pocketing the difference.

At one point, more than 100 per cent of GameStop’s stock was out on loan — an apparent oddity driven by the fact that a stock can be borrowed, sold and re-lent many times.

Line chart of Short interest as a percentage of company

Day traders realised that if they could actually push the retailer’s shares higher, that would leave its short-sellers facing big losses, forcing them to buy back the shares to “cover” their shorts, but then worsen the losses for other shorts and triggering a spiral higher for the stock. This so-called “short squeeze” proved successful, with Melvin and another short-seller, Citron Research, closing out their positions at a significant loss.

Other well-known short-sellers, such as Muddy Waters, moved quickly to cut back negative bets on other companies.

The dramatic stock market moves — in GameStop and elsewhere — have also been fuelled by day traders’ fondness for options, which offer the buyer the right to buy (call options), or sell (put options) a stock at a pre-agreed “strike price” within a certain time period.

Column chart of Millions of "degenerates" - as r/WallStreetBets calls members of its message board. showing Reddit

When an investor buys a call — in effect betting that the underlying stock price will move higher — the bank or other firm selling the option is on the hook to deliver the shares to the investor at the agreed-upon strike price if it is reached.

To protect itself, the dealer will continually buy the shares as they move towards the strike price, which encourages the underlying share price to rise further still. Some analysts say the day-trading crowd has learned to “weaponise” these dynamics, knowing that if they mount an organised buying spree, pushing the share prices towards the strike price, the so-called hedging activity will feed the rally. This is sometimes called a “gamma squeeze”. The effect can be magnified with certain companies that have a big proportion of shares out on loan to short-sellers.

The GameStop episode quickly spread beyond the retailer to other stocks that are under the attention of short-sellers, such as coronavirus-hit cinema operator AMC Entertainment and former Financial Times owner Pearson.

It has become a global phenomenon: on Friday, Malaysia-listed rubber glove owners soared after they were highlighted by users of the r/BursaBets subreddit. And it is not limited to stocks: the price of silver has risen in recent days after calls from Reddit users to squeeze the price of a popular silver-backed exchange traded fund and related stocks higher.

The Reddit crowd has not had everything its own way. Thursday’s trading was characterised by multiple trading halts and highly volatile price moves for the most sought-after stocks. GameStop fell more than 40 per cent on the day, and AMC fell more than 50 per cent, after brokers moved to restrict new purchases.

Many commentators have warned that the individual investors piling in to these hot stocks risk big losses when the euphoria fades — or when the businesses take advantage of the rise in their previously subdued stock prices to raise new equity, diluting existing shareholders.

AMC’s rally allowed its creditor Silver Lake to make what one investor called the “trade of a lifetime” by swapping risky debt for stock, after the share price rose past a trigger price embedded into the convertible bonds owned by the investment firm.

But the Reddit effect does not look to be going away quickly. Both GameStop and AMC were up strongly again on Friday. Hedge funds are hungry to scrape message boards to see which stock is next to catch the attention of the day-trading community. And r/WallStreetBets membership continues to grow.

Line chart of Five-day % performance, rebased showing GameStop and AMC

In the process, the business model of commission-free brokers is being tested, and short-sellers — who play an important role in price discovery and uncovering corporate frauds — say they are being more “judicious” in the companies they target.

The big question now is whether regulators will move to rein in the speculation. The US Securities and Exchange Commission said on Friday that it was monitoring the price volatility, adding that it would “closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.”