Hedge funds covering shorts might need to sell other stocks next

If hedge funds want to offset losses from going short stocks as well as reduce exposure in markets, they may sell other stocks and cause a market correction.

Must know

  • The most successful hedge fund managers were once dubbed 'Masters of the Universe'
  • Hedge funds Melvin Capital and short specialist Citron have covered short positions in GameStop GME at a loss (according by CNBC)
  • Reminder: Hedge funds historically got their name by being both long and short markets and being 'hedged'
  • Closing out short positions means hedge funds theoretically need to reduce risk exposure on the long side of their book by selling shares
  • Additionally, if short positions took a loss, hedge funds  might choose to offset those losses by taking profits from winning long positions.
  • A collection of hedge funds all selling stock together could push best-performing stocks lower and bring overall markets down with them

Hedge fund favourite stocks

There’s a chance that the markets have gotten so bullish that the affect will be bearish. There has been a correlation between the ramping up of the most-shorted stocks alongside selling in some of the most popular stocks among hedge funds.

 

Hedge funds selling favorite stocks to cover losses from short sales

 

Goldman Sachs ‘Hedge Fund VIP ETF’ has seen some of the sharpest declines since its was created in the last week.

A ‘retail army’ of investors gathering in chatrooms on Reddit and elsewhere are heavily buying stock and call options in some of the most heavily shorted stocks. As we detailed yesterday in our blog What is a short squeeze? GameStop example the resulting price gains have created a short squeeze where investors short the stocks have had to cover their shorts.

One hedge fund Melvin Capital received a multi-billion-dollar bailout from two other hedge funds Citadel and Point72, run by billionaires Ken Griffin and Steve Cohen respectively. On this basis it can be assumed there are a few hedge funds that are hurting out there from losses on short positions.

As a reminder, losses on short positions can exceed the amount of the initial capital in the trade because prices can in theory go up infinitely.

Gross leverage, a good proxy for overall hedge fund risk-taking has seen one of the biggest reductions since August 2009 according to Goldman Sachs and reported by Bloomberg.

What stocks could hedge funds sell?

If we go by the logic that hedge funds would want to sell top holdings and/or biggest winners, we can look to the Goldman Hedge fund ETF again.

The top holdings of the fund are as follows:

hedge fund top tocks

Source: Goldman Sachs

 

Unsurprisingly, IT - the best performing sector over the past 12 months and over the past decade features heavily.

GS hedge sectors

Source: Goldman Sachs

Conclusion

Something we are asking ourselves, If you're a hedge fund and you want to take profit on some big winners after taking a loss on GME and other short positions, when would you do it? One opportunity would be right after Apple (AAPL) Tesla (TSLA) and Facebook (FB) potentially get a last bump higher from what are expected to be record earnings tonight. Of course, said selling might not happen and/or the stocks that have been pushed higher in short-covering come back down - but let's see.

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