Hedge Funds’ AMC Doomsday Scenario

Hedge funds have been perfectly capable of blowing themselves up with common trades like shorting and selling call options. But with the epic rise of AMC Entertainment Holdings, Inc. stock, there lurks another potential danger for hedge funds. And this one could be worse than anything else we’ve seen.

Aside from shorting and options trades, another common way to bet against a company is to purchase credit default swaps (CDS). These are insurance on a company’s bonds. If AMC were to go bankrupt, that insurance would skyrocket in value, since everyone would want protection for their imperiled portfolio. But if AMC soars, that insurance could quickly become almost worthless.

Why would hedge funds turn to CDS to bet against AMC? Because they’re being cut off from their traditional bear trades like shorting and options. Many prime brokers, who process hedge fund trades, have banned such moves in AMC, GameStop and other meme stocks, afraid they’ll be left holding the bag if hedge funds can’t cover their losses.

The CDS market is massive, covering protection on over $10 trillion in credit. CDS is especially dangerous for several reasons. The market is extremely opaque; these derivatives are usually custom-made for each buyer and trade away from any exchange. The leverage available with CDS is unbelievable: buyers usually only need to put up 1% of the value of all the protection they want to buy. So, if a hedge fund plunked down $10 million, they could be exposed to the swings in a $1 billion portfolio of AMC bonds. Even a small drop in AMC’s default risk would have major implications.

CDS also includes a feature similar to margin calls in stocks: collateral. Both parties commonly have to post collateral when their position moves against them. If AMC stock continues to soar, making it easy for the company to raise money and taking bankruptcy off the table, a hedge fund’s CDS could plummet in value. The fund could face sudden and massive demands for collateral because its CDS covers such a huge amount of AMC bonds. These collateral calls could quickly bankrupt a hedge fund.

Will this doomsday scenario come to pass? Who can say? But with other avenues to bet against the likes of AMC rapidly closing and ever increasing pressure to redeem large losses, hedge funds may be attracted to this risky strategy.

A wiser path would be to avoid betting against anything with a cult following as powerful as AMC.

More on AMC:

Photo: “Scary clouds over New York City!” by Orangeadnan is licensed under CC BY 2.0

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