The stock everyone is talking about is GameStop. We remind our readers regularly that “Price Can Do What Ever It Wants.” This phenomenon is what makes trading so difficult. One can be right in the long-term but take a beating or lose everything before the long-term arrives.
What is happening with GameStop is unprecedented. We have never seen price action like this in all our years of making markets and investment decisions. GME makes the big runup in Tesla stock look tame by comparison. We thought it would be valuable to share our thoughts on what has happened as we believe the options market contributed to the rocket-like price action.
But before we get into that discussion, we have a philosophical thought. Why not crazy? Perhaps it is the new black. Maybe we should not be surprised. The Fed has destroyed price discovery. That is the process economic actors go through to determine the economic merits of transacting. It applied to all levels of trading. Do I buy an apple for X? Do I buy a house for Y? Do I buy ABC’s stock for Z.
Let’s stop a moment and reflect on what the central planners have been doing. Federal Reserve Act was signed into law by Woodrow Wilson on December 23, 1913. This new law authorized the establishment of a central bank. On April 2, 1914, the Reserve Bank Organization Committee announced its decision, and twelve Federal Reserve banks were established to cover various districts around the country. On that day, the Fed had no assets. Fast forward to 2008, and the size of their balance sheet increased to $1 trillion. It took 94 years for the Fed’s balance sheet to hit this milestone.
Nowadays, a trillion is a nothing burger. Look at what happened between 2008 and 2019. The Fed’s balance sheet quadrupled to about $4 trillion. But that is nothing compared to what happened in the last year. Just look at what the US Treasury accomplished with the aid of the Federal Reserve. They tossed $3 trillion down a money hole in a matter of months. The following chart shows that the annual budget deficit is now at nose bleed levels of $3.15 trillion PER YEAR. What is worse, there is no dialog about fiscal responsibility. So come to expect $2, $3, and $4 trillion per annum for as long as the eye can see. This is sure to result Keynes once said that “in the long run, we are all dead.” Taking this to heart, the adults have decided to pass the cost of their bad decisions on the children.
Compare the two charts. The US Fed Gov spends $3.2 trillion it does not have, and the Fed buys the debt with money it does not have but can manufacture out of thin air. This market intervention all happened in a matter of a few months. What is the result? The government and its allies broke all links between interest rates (the most important price in a free market economy) and macroeconomic fundamentals. So, should we be surprised to see the stock of a small-cap company go off the rails? We think not.
So let’s take a look at the mechanism that made Gamestop the biggest video game in town. It all starts with a company that is no longer needed in its current form. GameStop sells video games and hardware upon which those games are played. They also sell smartphones and some other light hardware. But they exist in a world where they are getting disintermediated. The company has over 5,000 physical locations. But people do not have to go to a store to download the gaming software directly from the manufacturers. But GME does participate in this activity and makes a buck doing it. The niche that GME possesses is that it is a place where people can trade in their old stuff for new stuff. In the end, the company has been losing money for the last three years as it searches for a business model that works.
Being a company that looks like it is headed to the graveyard of dead corporations, hedge funds should the company’s shares short as they bet that it was just a matter of time before the company filed for bankruptcy. According to Yahoo Finance, hedge funds and bearish speculators sold short 72 million shares on December 31, 2020. Bear in mind there the total float is only 47 million shares. So the short interest was 153% of shares outstanding. How can this number be so large? Rather simple. Let’s say a group of someones borrows and sells the 47 million shares short. There are now 94 million shares held as long positions somewhere. If more short sellers come in, there are still 47 million stock certificates floating around to borrow and sell. This action is a process known as re-hypothecation, allows for an infinite number of share to be sold short.
If the share prices start to rise, the short begging to lose money fast. Yesterday the share opened at $80 a share or so. If the share price rises to $160 (it closed at $148) the investor would lose all or more than the capital put up, depending on how much money they put up to collateralize the trade. But short-sellers are typically super short term, so they typically buy back their shares when the trade goes against them. As they buy back shares, they push the share price higher.
This process tends to bring in more hedge fund short sellers. If the $10 stock is overpriced at $30, it is really overpriced at $50. With a momentum push underfoot, momo buyers buy the stock from the new batch of short-sellers. This process repeats until the short give up. This markets a top and prices collapse. Stock prices typically rise on an escalator and fall on an elevator. So if one is adept, short sellers can make money fast. Such is the allure.
But there is a second part of the story that is not getting very much attention. Options traders call it a gamma squeeze. When market makers sell options to customers, they hedge the position with the underlying stock. Assume a customer buys 10,000 at the money calls. Such an option has a delta of 0.5. This means the call option will rise in price by $0.50 if the share price. If the share price rises by 10%, the delta goes to 0.6. To stay hedged, the market makers must buy more stock. This action pushes the price up higher still. Just as the short-selling provides a positive feedback look to the price action, the market maker does the same thing.
In the case of GME, the gamma squeeze was put on steroids. Why? Two days ago, there were 21,000, $200 February strike calls, sold short by market makers and bears, bought by the ultra bulls. (As an aside, over 100,000 of these options were traded during the day.) The stock closed trading at $77. Why would market makers make the sale? They could sell these options for about $13.00 or 1300 per contract. This is an extraordinarily high price for an option that is 150% out of the money.
The delta on these puts was about 0.05. So to hedge their position, market makers would buy five shares of stock per option. As the stock price moved to $120, the call’s delta increased to 0.10, and market makers had to buy five more shares per contract to remain hedged. By the end of the day, the continuous buying by market makers (and short covering) pushed the share price to $148 by the close of trading.
After the close, Chamath Palihapitiya & Elon Musk made positive comments and gave a vote of confidence to the bullish speculators. Their words lit the stock on fire, where it traded as high as $260 before falling back to $205 or so. After-hours trading is notoriously this to it is relatively easy for speculators to push a share price around with a modest amount of capital. This added to the feedback look, and the stock opened at about $30o bucks higher. Ultimately the share closed at $347. All the while the gamma squeeze forced the market makers and bears to buy 2.1 million shares of stock.
There is a lot of carnage suffered by hedge funds who trade a portfolio of longs and short to maximize investor returns. Melvil Capital had a monster margin call and had to put up $2.75 billion, which they borrowed from Ken Griffin’s Citidel and Steve Cohen’s Point 72. Even this bailout was not enough, and we read that Melvil finally pulled the plug and covered their short at a huge loss. (This is the kind of thing that happened at the end of the squeeze. The shorts lose all hope, cover their position and head off to lick their wounds.)
This story is fantastic enough as it is. But the story of how this got started is equally, if not more interesting. The investing community over at Reddit shares investment theses among members. Of note are the members of wallstreetbets. We understand that this is where the idea of buying the most shorted small-cap stock in the market place. As individuals, they have no might. But as a group, they can accumulate stock and push the share price higher.
It’s a whole new world out there. With the advent of cheap data feeds, individuals with programming, data analysis, and acquisition skills can compete with the professionals. In this case, they outsmarted the “smart money.” We suspect these kinds of events will become more commonplace. Time will tell.
Be careful out there. Remember, the price of an asset can do whatever it wants. When trading, the best form of risk management is to diversify and trade small. Do not be afraid to take a loss. The goal is to (1) preserve your capital, (2) make a buck, and (3) be sure to live to trade another day.
It seems the investment markets have been turned into a video game. “Trade by App” is now the norm with Robin Hood leading the way. Interesting how this band of merry men introduced themselves to the old-line investment establishment by running them over with a gaming company/retailer stock.
We do not have a trade suggestion for this situation. We think the risk and the capital needed is too high. We look for trades and option structures with high probability for success, and we do not see one yet. We suspect GME will be trading below $10 a year from now. What is uncertain is the path it takes to get there. It could begin that journey right away. But as we see in the chaos, the price might visit $500, $600 or any other random number first before returning to its intrinsic value. Further it could stay up at these lofty levels for a significant amount of time. Options are unbelievably expensive making them just as risky as the stock, and one has to get the timing right. This wild ride will end when the short sellers are gone.
Photo by Senad Palic on Unsplash
