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Commentary

The GME Short Squeeze And The Brilliant People At r/WallStreetBets

Gamestop-scaled.jpg

Gamestop shares have climbed to $148 yesterday after being at $18 on January 1, 2021. This remarkable run is the story of:

  • /r/wallstreetbets, a reddit group that, well, places bets on stocks
  • A couple of large hedge funds that like to go short
  • A retailer that might have just found a way to make back its lost days
  • The brilliance of the internet to organize a crowd in ways that were otherwise only used by big banks and funds

Read on.

Wait, what’s Gamestop/GME?

Gamestop is a retailer that sells video games. Not online, in physical form. Which has been a problem, because people are increasingly buying games online. Gamestop, listed as ticker GME in the US, has recently lost $275 million (Trailing 12 months) on revenues of $5 billion or so. (Which is quite remarkable, because with those revenues, it would be bigger than DMART in revenues alone – and all it does is sell games. You just have to be in awe of the US Market)

Anyhow, the point is that Gamestop was in a crappy business, and according to this excellent note by Matt Levine, Gamestop has been gaining interest because Ryan Cohen, the founder of Chewy, Inc (a pet food retailer that’s incredibly successful) has bought nearly 13% of the company, wants it to go bigger online, and has recently been added to their board of directors.

This would be good, but a rise from $18 at the end of 2020, to $111+ on Jan 26 is a little too much to fathom. What’s cooking?

GME Share

Enter /r/wallstreetbets

On a reddit forum called /r/wallstreetbets , something was indeed cooking. People started to discuss this stock as a candidate for the next big trade – the “YOLO” (You Only Live Once) bets that can make or break people’s lives. One such user named deepf***ingvalue, had put in a legendary $50K bet on GME in options. (This was September 2019)

That bet is now worth $13 million. And he’s probably booked more than $2 million out already.

This is the kind of thing that can make entire lifestyles change. That user has regularly been posting screenshots of his account which shows the meteoric rise, and obviously the 2 million users that make up WallStreetBets want in on the action.

And obviously there’s the little other factor that certain people are short this stock big time.

The 100% short interest in GME

A certain set of hedge funds are short $GME. One of them is Melvin Capital, run by Gabe Plotkin, who used to work with Steve Cohen at SAC Capital (a now infamous hedge fund). Melvin runs $12 billion and one of the bets it took was that the GME shares would drop in value. A typical short position need not make any attention, but Melvin had bought a large number of “put” options, which have to be disclosed. The value of these put options was $55 million – not a big percentage of the Melvin fund (less than 1%) but this formed a trigger for the move up as well.

Put options are bets that a stock will fall below a certain price, by a certain time. The idea of buying puts is that when you know a stock will fall, you might say look, if it goes up I don’t want to lose money, but if it goes down I want to make money. I will pay a premium per share for this one sided bet, and that premium is the amount I stand to lose. Technically, therefore, Melvin won’t lose more than $55 million on those puts.

WallStreetBets decided Melvin was going to be the fall guy, and they further piled on to the stock.

The thing no one seems to care about: According to this WSJ article, Melvin’s put options have since expired. It will lose no more on those puts.

The bigger problem is “short interest”. In America, you can borrow shares and short them. That’s how you profit from a down move – you sell first (borrowing someone else’s shares) and then buy back from the market later. The “borrow” costs money but you’ll bet that you make more after the fall than the cost of borrowing.

(You can do this in India too, but it’s limited)

If there are a 100 shares outstanding and let’s say the promoters have 80 and I have 20, then I lend those 20 to B, who sells them. The purchaser is C. Now C has 20 shares. I have 20. The promoter has 80. That adds up to 120! But the company only issued 100 shares!

It will only add up if you take the short interest = 20 shares. So the number of shares that people have in their accounts is 120, but there’s 20 shares of short interest.

Now let’s say C lends to D, who shorts in the market. E buys them. Promoters: 80, Deepak: 20, C: 20 and E: 20 shares. THat’s 140 shares, with short interest of 40 shares. Equivalently: the short interest is 40%.

All this sounds good.

GME’s short interest is more than 100%.

That’s the problem.

With 70 million shares outstanding, another 70 million shares are short. Depending on which site you read, you might find short interest at 140% as well.

The problem with being short is: for every $1 rise in the share price, you have to pay that $1 as a “mark to market” if you have borrowed shares. This “mark to market” loss for each rise means that the short seller eventually starts to hurt a lot. And then, to close out his position, the short seller will have to buy in the market and return the shares. When you buy into a market that’s already going up, you’re going to push the price up further.

This is a “short squeeze”.

What GME is going through is an epic short squeeze, because there’s more than 100% short interest.

And in fact, if Melvin Capital has shorts on (outside of the puts they own) they will be hosed. We’ll come to Melvin soon.

Wait, there’s more? Gaming the options market makers

The WallStreetBets people are buying options. Hey, even some large individual investors, like Chamath Pahilapitiya, is buying into this – he bought 5,000 shares (50 contracts, 100 shares each) just yesterday:

Chamath

Everyone’s piling on to the options trade. What is different about options?

Well, in the US, there are market makers who are on the other side. They “sell” the options. The options have an expiry date, so till that time the seller is exposed to the movement in the stock. They “hedge” this exposure by taking the opposite side, by buying or selling the stock itself.

Meaning: if Chamath bought the 115 call of GME, the market maker would have sold it to him. Let’s say Chamath paid $4 for each share. In order to hedge, the market maker would have probably bought 30 shares per contract (remember, each contract is 100 shares). Why? Because options don’t move exactly in proportion to the move in the stock. For a $10 move in the stock , the option will not move from $4 to $14. It will move from $4 to maybe $7. The move is 30% of the stock move, so the market maker buys 30 shares to hedge.

(Put another way – a 100 shares through options sold at $4 going to $7 will mean a loss of $300. 30 shares gaining $10 will move the share up by $300, so the position is overall hedged)

This is a “delta” hedge. Basically

  • people do not know how stocks will move.
  • Some of those people work in fancy named institutions and sell options
  • They hedge according to some fancy calculator that assumes life is normal,
  • Life as we know it is not normal, like in GME
  • You can’t have PhD degrees and admit you don’t know shit
  • So you call it incremental delta hedging or something fancy and hope it sticks
  • Usually it does because life is normal
  • You get the drift.

But what happens next? Since the stock is up now, and closer to the “strike” price of 115 (having moved up $10) the market maker will furiously redo calculations and say: Okay from now on, my calculations say I need to have 40 shares to hedge. That means I’ll buy 10 more shares.

As you can see, buying options in a fast upmoving stock forces market makers to continuously buy shares to hedge their exposure. The investment of $4 by Chamath – only $200,000 for, let’s say 50,000 shares, will result in buying of 100 underlying shares of GME (from $50 to $115, say, because they will buy more over time as the calculations show) which is $5 million of buying, if you consider an average price of $100.

(Note: Chamath seems to show only 50 contracts in that trade, I’ve assumed 500 contracts for the calculation above)

A $200,000 investment in options, resulted in a $5 million buy through market maker hedging.

Now imagine the WallStreetBets people – some 2 million of them – buying options. That’s massive massive buying.

Indeed, yesterday’s trading volume in GME was 178 million shares. To put that in perspective, at $100 average per share, that’s $17.8 billion. The ENTIRE Indian Stock Market trades about $10 billion per day.

And another way to look at it is: There’s only 70 million shares of GME outstanding, all added up. Even with 100% short interest, there’s 140 million shares available. And the trading volume is even higher – showing that there’s a lot of “intraday” trading – most of which is algorithmic and institutional.

It’s not just retail – it’s everyone getting in on the action.

  • Retail’s buying options
  • Some Hedge funds are buying options and shares possibly with intraday movements
  • Market makers are buying shares to hedge
  • Short sellers are having to buy to reduce the hit on their “mark to market” losses
  • Large individuals are also piling on through options

The result: The GME share is at $148, giving it a valuation of nearly $10 billion.

Can this change the fundamentals for the company?

In a demonstration of true reflexivity, this is a boon for the company in another way. It has very little income, and this brings the co into the limelight. Companies pay a lot of money to get into the limelight. GME doesn’t have to. Assume they announce a big move tomorrow – to purchase, say, an online game store or something, using their new currency: their stock. This automatically can change the fundamentals by allowing the company to get profitable through acquisitions.

Second, they  seem to have a large amount of debt – between $500 million and $1 billion. If they now issued new shares to institutions, this would instantly allow them to have access to money that can be used to repay debt – and thus increase profits. And selling shares when a short squeeze is on, is a great thing – your hit to the Return on Equity is substantially lower.

This is true reflexivity.

A share price is supposed to reflect the fundamentals of a company. Here, GME was struggling. But the share price increase can allow it to do things that change the fundamentals. The observer becomes the influencer. You can see this in action.

The travails of Melvin Capital, Citadel and Steve Cohen’s Point72

Melvin Capital is hurting. They apparently had to raise money to be able to make it through, and raised $2.75 billion from two players: Point72 and Citadel.

Point72 is a hedge fund run by Steve Cohen, who owned SAC capital, where Gabe Plotkin of Melvin used to work earlier. Citadel is run by Ken Griffin, and is a very big market maker and hedge fund in the US markets. Famously, Griffin made a big move in 2006 when a similar “short squeeze” in Natural Gas forced a large fund, Amaranth, out of business. Citadel teamed up with JP Morgan, which was the clearing bank for Amaranth, to buy Amaranth’s assets for a paltry sum – and earned billions in the process.

(Read the entire story)

Citadel has another piece in the GME pie. They pay Robinhood, a free brokerage in the US, for “order flow” – the ability to see trades from users before they hit the exchange. Most of the WallStreetBets crowd seems to be on Robinhood. So it’s quite likely that Citadel is aware of the massive move up in prices through massive retail buying – and is easily capable of trading on that information (which is legal – anyone who’s on that sub-reddit is aware of the insane momentum)

This is now another phase – where soaring prices cause demands for more collateral for margins, and the margin demands force the short funds to raise more capital, which comes from players that might be benefiting from the price rises in the first place.

Can This Happen in India?

Oh of course. Here it may not happen through massive retail buying all the time, but there are such moves. Most famous was the Reliance Bear Attack in the 1980s – Listen to our podcast (with transcript) on this.

More recently, there was a massive move on a stock called Ackruti Realty (now called Hubtown) which made the stock move up only about 5x in the F&O market. A story on that soon, but it’s also quite amazing – where large players bought the stock just to hurt some players that were short.

In general, Indian stocks have relatively low “float”. Institutions are aware of this, and many players try to corner any large blocks of shares coming to the market, which means the relative supply remains low. And then, promoters too will use this mechanism to raise the price of the shares up and then do a massive institutional placement. Which helps their fundamentals, so the reflexivity kicks in. Everyone kinda-sorta wins. Some short positions will lose but so what.

One key difference in India is that options are not market-made like the US, so large players do not buy stock to hedge out delta risk

What’s Next?

Elon Musk is getting into the commentary. With one tweet, saying “Gamestonk!”. GME is at $209 after hours. It’s basically on fire. (Correction: it’s above 300 now. Gets worse. We stopped proof reading. Too much price risk)

Things are going to end badly, maybe, but at $10 billion in market cap, this is not significant in any systemic impact kind of way. What it does though is:

  • Make heroes out of the redditors – and most deserve it.
  • Make some people rich enough to write books about it – because all you need is one big trade.
  • Encourage a lot of people to do this – and we will not hear of the silent graveyards of those other trades, ever.
  • Force SEC to “investigate”, but I don’t think any thing here is illegal.
  • This is how most big funds do it anyhow – squeeze out a short player that needs to place collateral or margins. Even the legendary LTCM was forced into liquidation by some large banks
  • Only now, the unsophisticated retail is getting in, and getting in big
  • Of course, the regulators hate the small guys, so they will kick up a fuss, because how dare the David bully the Goliath etc.

The problem is really in the third point above. Because of this, insane YOLO-style risk taking will be encouraged. And at a larger level, that will have systemic impacts. There will be big losses, and then people will crib that the system is against them etc. Until the next person wins her YOLO trade and everyone piles on again, and the story continues.

What was done on the phone earlier, and in “bucket shops”, and so on is now done on the internet, on whatsapp, on twitter and so on. This is one of those times when a lot of people get to see incredible profits in a really short time. We, as the boring old players who want to know what “fixed asset turnover” is, should understand that there’s a factor affecting your stock that isn’t taught in books: The impact of a herd.

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