The Big Short part II: the GameStop Short Squeeze

Trading

If you’ve been following the news lately you probably saw something about RobinHood, Reddit and stock manipulation triggered all by the GameStop Short Squeeze.

Currently one of the biggest fights between Wall Street and the (self-called) Retards is going on.

And the Retards are winning big time.

Let me get you into what is happening.

Oh, and Retards is an anagram for Traders. And they were called  retards during an interview on TV.

 

GameStop going down the drain

First, for those of you who are unfamiliar with GameStop. It is a videogame and merchandise retailer.

It has over 5,000 stores, primarily in malls, across North America, Europe, and Australia.

Which is clearly a dying business model. Who goes to a store to buy games nowadays?

And  not only because of the ease of shopping online, but with the pandemic going on, all the malls are dead as well.

The business has struggled to modernize and adapt to the changing customer demands, hurting it’s financial and thus stock performance.

So some hedge funds are betting the stock would go down a lot and built a short position in GameStop.

One of those hedge funds is Melvin Capital Management.

Find a short Short Selling 101 down below.

 

Robinhood abruptly restricts transactions for GameStop stock - ABC News

 

Or might GameStop turn around?

But for a variety of reasons, an optimistic case regarding the future performance of GameStop has formed.

It really came to the forefront after RC Ventures, an entity managed by Ryan Cohen, disclosed a large position and assumed three board seats.

Ryan Cohen is also the co-founder of Chewy, which is an online retailer of pet food and other pet-related products based.

In 2017, Chewy was acquired by PetSmart for $3.35 billion, which was the largest ever acquisition of an e-commerce business at the time. The company completed its initial public offering in 2019, raising $1 billion. Wikipedia

“We are excited to bring our customer-obsessed mindset and technology experience to GameStop and its strategic assets…expanding the ways in which it delights customers and by becoming the ultimate destination for gamers.”

At the time of that statement on January 11, the GameStop stock was trading at about $20 per share.

 

 

Since then, the stock has quickly doubled to $40 per share and started capturing the public imagination.

In a matter of two weeks GameStop traded as high as $480 per share.

That is an incredible 2300% return from the initial $20 per share.

 

 

 

So what triggered this GameStop short squeeze?

Off course the bullish news was a catalyst that started the price to go higher.

But that was not the driving force behind this insane run up.

What was?

There are two dynamics at play here:

  1. a short squeeze
  2. a gamma squeeze.

In short for both cases it means that the ones holding a position betting against a collapse of the stock price are forced to buy the underlying stock in order to cover their positions.

And both squeezes were perfectly orchestrated to happen and break the shorting hedge funds.

Further down in this post I explain both a short squeeze and a gamma squeeze for a better understanding.

 

Reddit is Killing GameStop 🚀 - YouTube

 

Reddit Breaking Melvin Capital Management

One fund in particular, Melvin Capital Management – a multi-billion dollar hedge fund had been accruing a big short position in GameStop.

Usually you don’t have to disclose your shorts – but these were ‘listed put options’ so some clever Redditors discovered the position.

Melvin had a $55M+ short against GameStop.

In this case Redditors saw the overloaded short position of the hedge funds and started buying the stock, in order to trigger a “short squeeze” against Melvin Capital Management.

Now the “borrowed” shares were due and needed to bought back.

But all Redditors refused to sell, demanding higher and higher prices for the GameStop stock.

To be clear: this has nothing to do with GameStop as a business.

They are just a piece of rope being used in a tug of war between internet nerds and Wall Street suits.

The rally cry on r/wallstreet bets: “We can remain retarded for longer than they can stay solvent!”

Melvin Capital Management lost $2B+ in about 2 weeks.

They had to get bailed out by 2 other funds just to cover it’s losses from the shorts.

It’s not quite George Soros “Breaking the Bank of England” – but it’s getting close.

The big difference here is that this is not done by a professional investor, but by the yolo traders of Reddit. And they just broke multi-billion dollar hedge funds.

 

The Quarantine Stream: 'Robin Hood: Prince of Thieves' is '90s Entertainment Worth Revisiting – /Film

 

How RobinHood is turning against their customers

While hedge funds and investments banks have engaged in fraud, manipulation, money laundering and gambling with the entire world’s economy, they were outrageous by the idea that a bunch of Redditor plebs dare rekt their trades.

To squash the rebellion, brokerages like Robinhood, TD Ameritrade, and InteractiveBrokers starting blocking their traders from trading GameStop and other stocks that Redditors were squeezing.

In order to prevent the squeeze to continue and protect the hedge funds.

Even Discord, a popular chat service, shut down WSB server for “hate speech” after trading hours. That’s when institutional investors have a huge advantage over retail traders.

This strategy of blocking trading for one party will not work.

You can’t kill an idea.

More and more people are rallying behind r/wsb because it’s NOT an institution or organization.

r/wsb extends beyond just a subreddit or Discord group, it’s a mindset.

Billions of people are tired of being run over by the big guys and are fighting back.

These legacy financial institutions that we trusted had a veneer of credibility which has recently been shattered.

Starting with a fracturing of that trust during the 2008 financial crisis, the trust is now reaching a breaking point with COVID.

On Reddit there is An Open Letter to Melvin Capital, CNBC, Boomers, and WSB that is a touching explanation of the underlying feeling among the little man.

 

So what is the GameStop Short Squeeze all about?

As you can read in the open letter above this movement against the hedge funds is about much more than just this one trade.

It is a movement against the established financial industry that caused the 2008 crisis and, since then, hasn’t changed a bit.

The financial market is a rigged game in favor of the big guys.

Internet is making it a level playing field by giving everybody access to information, communication tools and easy and direct access to the stock market.

The little guys found out a mistake from the big hedge funds.

Those mistakes from the big guys are now directly being punished by the little guys.

And the big guys are crying that they are now being beaten at their own game. They’re even looking for companies like RobinHood and Nasdaq to rescue them.

Look at this:
Nasdaq CEO Suggests Halt to Trading to Allow Investors to ‘Recalibrate Their Positions’ After GameStop Surge

This GameStop Short Squeeze is all about the feeling of inequality in the world. 

 

 


So as promised earlier in this post let me take some time to explain a couple of concepts that are playing out in this trade.

These are greatly inspired by (and copied from) Sahil Bloom who writes amazingly clear threads on Twitter to explain business and finance.

Make sure you check him out: https://twitter.com/SahilBloom

 

Short Selling 101

 

When you believe a stock is going to rise in value, it is called being long the stock, you’re bullish on it.

When you believe a stock is going to decline in value, it is called being short the stock, or you are bearish.

Short selling is simply how you bet on the decline in value.

Imagine you read that Colombia is experiencing a very wet Summer. You believe this will lead to a huge coffee harvest, flooding the market with coffee and driving down the price. You want to profit from this. So you borrow a bag of coffee from Jimmy, your neighbor.

You sell the bag of coffee to Paul, your other neighbor, for $20, the price of the bag at your market. You now have $20 but you owe Jimmy a bag of coffee (you borrowed it, after all). One month later, the price of coffee drops 50%. You buy a bag at the local store for $10.

You walk over to Jimmy’s house, hand him the new bag of coffee, and give him $1 as interest on the borrowed bag. So you sold a borrowed bag for $20 and then bought it back and returned it for $11 ($10 plus $1 interest). You’ve made $9 profit on your coffee “short” position!

Of course, if you had been wrong and the price of coffee had risen, you still would have had to “cover” your short by buying a bag and returning it to Jimmy. You would have lost money. Because the price can rise infinitely (in theory), losses from short selling are uncapped.

So this is a quick primer on the topic – Short Selling 101. I hope it was helpful! Disclaimer: Only experienced traders and investors should think about short selling as a strategy. Given the uncapped losses, it is inherently a more risky strategy than going long.

 

Short Squeeze 101

 

If you follow financial markets (or if you watch Billions), you’ve heard the phrase “short squeeze” used quite frequently. But what is a “short squeeze” and how does it work? Here’s Short Squeeze 101!

“Short interest” is a measure of how heavily an asset is shorted by the market. It is the total number of shares that have been sold short (borrowed and sold), but have not yet been covered (bought and returned). It is usually measured as a % of the # of shares outstanding.

A “short squeeze” occurs when a heavily-shorted asset experiences a rapid upward price movement. When this happens, short sellers may be forced to close their short positions (i.e. buy the stock and return it to the broker), further accelerating the upward price movement.

Let’s look at a simple example to show this in action. We will use Tesla, one of the most heavily-shorted stocks in the world. Imagine the stock price is $1,000 per share. This seems crazy. Ricky Rational decides to short the stock at this level.

Ricky borrows 1 share from his broker, agreeing to return the borrowed share in the future. He sells it short at $1,000. If the price declines, great. He is now able to buy a share at $800. Ricky returns that share to his broker and closes his short with a $200 profit!

If the price rises, not so great. His broker gets nervous about his ability to pay and forces him to replace the borrowed share. He buys a share at $1,200 and closes the short in a loss. In both cases, the “closing” of the short requires a purchase of shares of the stock.

Therein lies the makings of the short squeeze! If Tesla stock rises rapidly (which it does far too often), Ricky and many others may all be forced to close their shorts at once. This creates a surge of buying (to return the borrowed shares) and drives the price up further.

Short sellers are literally squeezed out of the market. You can track short interest in specific stocks to determine when one may be occurring. So next time you see a chart that shows a sharp rise, followed by another, even sharper rise, you may be seeing a short squeeze.

 

Call Options 101

 

In simple terms, an option is a contract. It gives the buyer the right, but not the obligation, to buy (a “call”) or sell (a “put”) an asset. It specifies the price at which the asset can be bought or sold (“strike”) as well as a date this must occur before (“expiration”).

The buyer of the option has to pay to have that right to buy or sell. The “premium” is the price they pay for the option. Let’s use a simple example to illustrate how this works. In this thread, we will cover the call option. (Don’t worry, Bears, I’ll cover the put soon!)

Imagine you are in the market for a new house. You find the perfect one in a town nearby. You hear the town may get a nice new mall, so housing prices may rise quickly. Paul, the house’s owner, wants $1M for it. You don’t have that kind of money today, but you will soon.

You don’t want Paul to put the house on the market. You worry someone else will snatch it up! So you offer Paul a deal. You’ll pay him $50K today for the right to buy the house for $1M before December 31. Paul agrees to the deal.

Congratulations, you just bought a call option!

Strike = $1M
Expiration = December 31
Premium = $50K

One of two scenarios now plays out:
1️⃣ – Mall Built = 🏠 Prices ⬆️
2️⃣ – Mall Not Built = 🏠 Prices ⬇️

In scenario 1, you “exercise” your option to buy the house for $1M. You are happy. The house is worth $1.2M now and you got it for $1M (plus the $50K option premium). In scenario 2, you don’t exercise. The house is now only worth $900K. You’re only out the $50K, so it’s ok.

So you were effectively in control of a $1M house for only $50K. There are more nuances to this – selling/writing, pricing dynamics – but we can save those for 102 and 103! I hope this was a helpful primer! Stay tuned for part 2 of Options 101, where I’ll cover put options.

 

Gamma Squeeze 101

The gamma squeeze is a bit more complicated. As usual, let’s simplify it here for everyone to understand. A gamma squeeze is all about options contracts and their indirect impact on the underlying stock.

When you buy a call option on $GME, someone has to sell you that option contract. You pay them a bit of money (the premium) and they make a commitment to deliver you the underlying stock at a future date for the strike price of the option. It’s a pretty simple transaction.

But in the background, the seller (often called a “market maker”) has to think about their risk exposure. If $GME rises above your strike price, they will have to buy the stock at the market price and sell it to you for the strike price, incurring a (potentially large!) loss.To hedge this risk, when the market maker sells you the option, she also goes into the market and buys a bit of the underlying stock. The amount of stock she buys is based on the “Delta” – a ratio of how much the option price moves relative to a $1 move in the stock.

“Gamma” is the rate of change of the “Delta” of the option. As Delta and Gamma rise, the market maker gets more and more nervous! She has to buy more stock to hedge the risk of the option being exercised in the money (i.e. with the underlying price above the strike price).

So here we have the (simplified!) makings of the gamma squeeze. As call option purchasing volumes suddenly surged (thanks to @wallstreetbets @chamath and @ElonMusk), market makers had to purchase a lot of $GME stock to hedge. This set in motion a self-fulfilling prophecy…

Market makers rushed to purchase $GME stock to hedge exposure. This drove the price of $GME up! As the price of $GME went up, the Delta and Gamma of $GME call options rose. This meant market makers had to buy more stock, further driving up the $GME price! Reflexivity!

So to summarize:

With $GME, we had both (1) a short squeeze – short-sellers frantically buying the stock to close/cover their shorts and (2) a gamma squeeze – call option market makers frantically buying the stock to hedge their exposure.


 

So, hopefully you now understand a little more about what is going on in this GameStop Short Squeeze.

Where does it end? I have no idea.

All I know is that there is a massive movement going on against the big guys, and I don’t see it stopping anytime soon.

Mic Swearing GIF - Find & Share on GIPHY

 

Buckle up if you are looking to trade this frenzy, or (probably better) enjoy what’s going on from a save distance.

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