How to Profit From Hedge Fund Forced Selling

How to Profit From Hedge Fund Forced Selling

Posted On March 30, 2021 1:32 pm

Hedge funds are often thought of as the “smart money” on Wall Street. At least based on their very high fees (as much as 2% of assets and 20% of profits) investors would hope that they were the smartest guys in the room.

However, often big funds can get into trouble, and create incredible opportunities for regular investors to profit from margin call-induced forced selling.

That’s what happened in mid-March 2020, and it’s what’s happening now.

Now it seems reasonable to assume that quality companies can’t fall by crazy amounts as we saw in the panic days of the early pandemic.

However, the nature of forced selling is that it’s inherently non-rational.

  • if a big fund gets a margin call or has to liquidate to meet redemptions, then fire sale prices can be the result

Even in a thriving economy, the best in almost 40 years, individual companies can fall off a cliff.

  • Viacom is down 53% in a matter of days
  • one of the fastest bubble deflations in market history

So let’s take a look at what in particular is causing one of the fastest stock market crashes (for VIAC), as well as a handful of other popular names such as Alibaba.

Why Certain Stocks Are Falling Off A Cliff

Archegos manages the personal fortune of the former hedge fund mogul Bill Hwang, who won Wall Street’s business despite having pleaded guilty to insider trading years ago. It amassed huge positions in media giants like ViacomCBS and in several Chinese tech companies — largely with borrowed money.” – Dealbook

The hedge fund in question is primarily acting as a private home office to a single billionaire who apparently wanted to speculative with options and derivatives.

The Archegos strategy included using swaps, contracts that gave Mr. Hwang financial exposure to companies’ shares while hiding both his identity and how big his positions really were. (It is also becoming increasingly apparent that several Wall Street banks lent Archegos money without knowing that others were doing the same thing for the same trades.)” – Dealbook

Options and swaps are a way to leverage your bets and are a glorious thing when a stock price is soaring.

(Source: FAST Graphs, FactSet Research)

Mr. Hwang and Achegos must have felt like geniuses leveraging the likes of VIAC, as it became one of the hottest stocks on Wall Street.

Trouble for Mr. Hwang, and his banks, arose when the prices of those stocks started to fall. That prompted some of his lenders to demand cash to cover his bets. When they began to question his ability to do so, some of them, including Goldman Sachs and Morgan Stanley, seized some of his holdings and kicked off the sale of $20 billion worth in huge block trades.” – Dealbook

Of course, leverage cuts both ways, magnifying profits on the way up, but also losses to the downside.

The block sales were $20 billion as of last Friday, $30 billion as of Monday and CNBC is reporting that Wells Fargo is potentially preparing a 17 million share VIAC block sale (about $800 million worth) as I write this on Monday morning.

Block sales are not made on the open market but are private deals usually at a steep discount.

  • FactSet Research reports Goldman sold shares of BABA on Friday March 26th as low as $185, the stock closed at $227 that day

Credit Suisse and Nomura acknowledged being hit especially hard. Credit Suisse told investors that a “U.S.-based hedge fund” had defaulted on its margin calls, which could lead to losses that were “highly significant and material to our first-quarter results.” Nomura said that one of its U.S. arms could suffer “a significant loss” because of the forced sales. Shares in Credit Suisse were down 14 percent this morning; those in Nomura were down 16 percent.” – Dealbook

The results of financing wildly speculative SWAPs and option bets for Archegos has been potentially billions in losses for the likes of Credit Suisse and Nomura.

Some investors are naturally concerned of possible contagion from this single billionaire’s home office potentially triggering cascading crashes throughout global financial markets.

  • in 1998 Long-Term Capital Management almost brought down the entire financial system
  • The Fed, working with other private banks and financial giants, bailed it out and averted disaster

However, the chances of such a worst-case chain reaction are small.

“Goldman, on the other hand, has told investors that its potential losses are “immaterial,” having covered its exposure.” -Dealbook

There are important lessons to learn for Wall Street’s big banks.

“Some bankers told The Financial Times that Archegos’s downfall highlighted the risk of one firm taking on so much leverage from multiple banks. (It also raises fresh questions about whether the mania for meme stocks, largely attributed to day traders, was actually fueled by hedge funds jumping into the trading.)

The good news is that we likely won’t face anything close to the LTCM fiasco of 1998. The bad news is, at least for some investors, things might get a lot uglier.

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Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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