Short squeezes, gamma squeezes, and the GameStop drama

Short squeezes, gamma squeezes, and the GameStop drama
Short squeezes, gamma squeezes, and the GameStop drama

Introduction

Video game retailer GameStop is up nearly 800% in the last two weeks. The story of how this happened makes for both an entertaining soap opera and an educational example of some market-making forces every trader should be aware of: short squeezes and gamma squeezes. Buckle in to learn how reddit vigilantes took on activist short-sellers and caused a massive spike in a struggling retail stock.

Act 1: The Citron short

The story begins with a brief video released by activist short-seller firm Citron Research in which Citron’s Andrew Left announced a short position in the stock. The video wasn’t really up to Citron’s usual standards. Usually they expose some kind of fraud when they take a short position, but this time the argument was that GameStop was a low-quality company in a doomed brick-and-mortar retail sector and is not going to be able to turn itself around.

Here let me pause to define some terms:

“Short-sellers” are traders who borrow shares of a stock, sell the borrowed shares at current market price, and then buy the shares back later in order to return them to the lender. If the stock goes down between the sale and the purchase, the short-seller pockets the difference as profit. If the stock goes up, the short-seller takes a loss.

“Activist” short-sellers are a special category of short-sellers who do research in order to find poorly managed or fraudulent companies, take a short position on them, and then release their findings to the public in the hope that the release of negative information will drive the stock price down.

Act 2: The Wall Street Bets squeeze

Activist short-sellers have played a role in exposing nearly every major corporate fraud that’s ever been taken down. In my opinion they perform an important market function and offer an important service to investors. But a lot of people hate activist short-sellers. They’re often accused of releasing false or misleading information in order to manipulate a stock, and plenty of critics also feel that short-sellers are unpatriotic, pessimistic, and destructive. If you watched The Big Short and hated all the main characters because they were trying to destroy the banks and betting against the American economy, you’d probably also hate Citron Research. That’s how the folks on a subreddit called “Wall Street Bets” feel about Citron.

Activist short-sellers often get hacked, threatened, and bullied, but usually it’s by agents of a fraudulent company they’ve targeted. (Invisibilia’s episode “Trust Fall” documents a recent horrifying case involving the fraudulent mafia-connected German fintech company Wirecard.) The GameStop case is a little different because it was Internet vigilantes, and not corporate agents, who targeted the shorts. Left and other GameStop shorts came under an intense barrage of verbal assaults and cyberattacks from members of the Wall Street Bets subreddit who believe in GameStop’s turnaround story. And that’s not all the vigilantes did. They also coordinated a campaign to manipulate GameStop’s price upward and “squeeze” the shorts out of their trade by buying lots of far out-of-the-money GameStop calls. This campaign has been tremendously successful, as evident from the stock’s recent price action. Citron’s Andrew Left posted a video on Twitter in which he announced that as a result of the backlash, he has exited his GameStop short trade.

Here, again, let me pause to define some terms:

The problem with short-selling is that your losses are potentially infinite. If you’re short on a stock whose price price increases more than 100%, then you can lose more than 100% on your trade. If you don’t have enough cash in your account to cover the loss, then this can trigger what’s called a “margin call,” where you’re forced to buy shares in order to “cover” your short. And if your short position is large enough, there may not be enough shares for sale on the open market for you to quickly exit your trade, so it may take some time for you to cover. This can cause a dramatic increase in stock price, known as a “short squeeze.”

There’s another kind of squeeze called a “gamma squeeze,” which occurs when someone buys a lot of far-out-of-the-money call options on a stock. The sellers of far-out-of-the-money call options usually will buy shares of the stock in order to cover themselves in case the options eventually get exercised. That drives up the stock price. Plus, there are a lot of algorithms out there that buy or sell stocks based on what open options contracts imply about the market’s expectations for a stock’s future price. So buying out-of-the-money call options can also trigger those algorithms to buy, further driving up the price. In the last couple years, retail options traders, especially on the Wall Street Bets subreddit, have realized that they can manipulate stock prices by banding together to buy lots of out-of-the-money calls. This strategy has been successfully used for over a year to drive up the price of Tesla , and now it’s being used on GameStop with similar impressive results.

Conclusion

The biggest moral of the story here may be, don’t sell shares short. It’s a dangerous environment for short-sellers, with gangs of vigilante longs roaming the social media streets. The GameStop and Tesla stories prove that retail traders, if they band together, have the power to be market makers and to take on institutions. It also proves that markets aren’t necessarily efficient or rational. Sometimes they are a battleground for differences of ideology or social class, and the underlying company fundamentals matter not at all.

Of course, this likely won’t go on forever. Using a gamma squeeze to manipulate a stock price is arguably illegal, so there’s a possibility that the SEC will eventually crack down. Gamma squeezes also require the existence of market makers willing to sell far out-of-the-money calls, and it’s possible that that willingness will go away. If market makers stopped selling these calls on GameStop or Tesla , the game would quickly be up.

And finally, I think we will see companies increasingly position themselves to take advantage of these situations. The ideal move for GameStop executives would be to issue a lot of new shares right now in order to harvest the manipulators’ money and raise enough cash to cover the company’s future losses. ( Tesla has done this a few times in the last year or two.) And, as it turns out, GameStop has an offering ready to go, through a program they put in place on December 8. (Possibly they had advance notice of this coordinated Wall Street Bets program to manipulate the stock.) They only have to pull the trigger, which I assume they will do when they feel the stock has hit its peak. That is likely to trigger a sell-off in the stock, but it could also potentially stabilize the company’s finances, stave off bankruptcy, and greatly extend GameStop’s life.

And that’s another reason why fundamentals sometimes don’t matter and why it’s dangerous to be short on a stock: because to some extent, it’s the stock price that drives a company’s success rather than the other way around. A higher stock price allows a company to raise more capital, and more capital allows the company to invest in updating its business model and turning things around. Perhaps we will see this run in GameStop’s stock price lead to large capital expenditures, a new business nodel, and a total revitalization of the company. Only time will tell.

28 Jan Update : The Robinhood app (favorite of individual stock traders with small accounts) has dropped support for buying of GameStop, BlackBerry, and AMC stock after weeks of frenzied speculation in these stocks. TD Ameritrade has also suspended some types of transactions. Trade traffic is so high that many brokers had website issues yesterday. Speculators are now piling into American Airlines and– wait for it– Blockbuster Video’s liquidating company. A friend reports that Facebook is blocking his posts about Blockbuster.

This is the craziest stock market I’ve ever seen, not only in terms of price action, but also in terms of class war played out in financial markets on a massive scale. The small speculators have been out to “stick it to the suits.” For a while the suits seemed content to play along, even to profiteer from the revolution by front running the retail trade. (I suspect bandwagoning by hedge funds is responsible for some of these dramatic price moves.) But today the counter revolution appears to have begun.

29 Jan Update : So it now appears that the reason Robinhood and banned buying these stocks is because so many of their users were buying on leverage (borrowed money) that Robinhood came right to the brink exceeding the maximum amount of leverage allowed it under federal law given its capital reserves. Robinhood has restricted crypto trading today as well.

These are the sorts of things that happen in a bubble, tbh. Massive leverage, liquidity risks, trading restrictions, brokers in peril; it all increases the risk of a major volatility event. Take care out there.Jan 29Comment: SEC just announced it will investigate brokers that placed restrictions on trading, including presumably Robinhood.12 hours agoComment: According to CNN, Robinhood got a $3 billion margin call at 3:30 AM on Thursday. That’s an enormous sum, and it triggered desperate measures on Thursday, including the ban on trading GME and AMC, and the forced selling of many users’ shares of these stocks.

30 Jan Update :Then the CEO went on CNBC Thursday evening and denied that Robinhood had a liquidity issue, which arguably was a misrepresentation of the situation and could be subject to penalties from the SEC.

This is an exact replicate of the original post here :Short squeezes, gamma squeezes, and the GameStop drama for NYSE:GME by ChristopherCarrollSmith — TradingView

written by ChristopherCarrollSmith

Twitter : Wall Street Petting Zoo (@WSPZoo) / Twitter

You may also like...

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: