The GameStop conundrum

This week we saw a huge play come to its climax. For a while the retail investor community at r/wallstreetbets (WSB) on Reddit has been pumping several stocks that have been targeted by short sellers (mostly in the form of big hedge funds). GameStop (GME) was among the most prominent ones (others include AMC, BB, BBBY, NOK, etc.). The pump was done on the aforementioned subreddit, spilling over onto other social media platforms like Twitter where many retail investors, bystanders, billionaire businessmen, and even celebrities have joined in to push the stocks up in the massive short squeeze against the short sellers. 

Why has this caught so much attention? The motivation of the WSB community was driven by the fact that many short positions in these companies were overleveraged. GME for example had a short interest at 140% of its float. This means that there was more demand for borrowing stocks to be sold short than the number of stocks in circulation (this article explains the mechanism really well). Obviously the short-sellers were too exposed to the risk of this price going up, and the WSB community saw an opportunity to exploit this by doing exactly that: pushing the price up to break the shorters. All they needed was to build momentum. Last Friday was when the stock first took off (up 50%, from $43 to 64$), but it was from Monday this week when the stock really started rallying. It finished Wednesday at $347, up 540% since last week. The hedge funds shorting the stock are estimated to be down by at least $5bn (this was the estimate based on Tuesday data) as a result of the squeeze. The total short loss yesterday was estimated to be around $70bn (for other companies as well, not just GME). 

Then yesterday, all the major brokerage houses decided to shut down buy orders for GME and AMC (among a few others), in order to limit their own potential losses out of fear of their clients not being able to make collateral to cover the losses, which would then fall on them. This sparked outrage among the WSB traders and around the entire retail investor community, given that a limit to buy orders naturally sent the price down (from $357 to $193). This allegedly allowed hedge funds to either close or reload their short positions, thus easing the pressure, albeit temporarily, from the brokers (also, Robinhood reportedly raised $1bn yesterday from its investors). Price is back up to $380 before trading today, and will probably continue to go higher, given that retail investors are looking for other avenues using brokers that haven't placed any stops on trading.

GME price movements from Friday, Jan 22 to before-hours trading on Monday, Jan 25th

GME price movements from Thursday, Jan 28th to before-hours trading on Friday, Jan 29th

Short-selling is a risk-amplification strategy

Why is all this problematic? A hedge is defined as a protection against risk. Basically if you are long in certain equities (or other assets) you typically take a small short position as well (mostly in the form of put options on the stocks you are long in), to act as protection in case of a major market decline. So if the markets go down 10, 20, 30%, your put protection (on individual stocks or the market index in general) makes sure you fall down much less, or even profit from the decline. Taleb calls this an antifragile strategy - you gain from disorder. Your losses are limited only to the size of your position, while your gains are exponential. Hence, the best way to hold short positions that can amplify your gains during bad times (whether we're talking about a general market decline or an individual stock decline) is to trade option contracts. 

A classic short-selling strategy is much more risky than holding a put option contract. For one, your losses during short-selling are potentially infinite, while your put losses are limited to the size of the put. In classic short-selling you borrow shares from a market maker and oblige to return it back to them, for a fee, at a pre-specified date. You sell them immediately as you bought them and hope that the price would go down. If it does, you buy them back at that lower price and return them, pocketing the price differential as profit. However, if the stock price goes up instead of down, you have to borrow more money to buy back the shares. The higher the price goes, the worse off you get, meaning that your potential losses are bounded by how high the price goes up (in theory infinite, but in practice the worse short-sales gone wrong have delivered losses of several hundred percent). 

A hedge fund that engages in classic short-selling is, therefore, not hedging against risk, it is amplifying its exposure to risk (unless, of course, a fund is investing based on privileged insider information - the trading risk is basically zero in that case, but there is a risk of getting caught breaking the law).

In other words, if the hedge funds held their short positions via put options they would have only lost the size of the position - and this would happen only if the WSB crowd would keep inflating the bubble until the options expired (which would take a few months or maybe a year, depending on which option contract was bought). In the current case, the time interval the WSB crowd has to endure is much shorter, given that brokerages apply margin calls on major loss positions. Earlier this week, the fund alleged to be most exposed to the GME short, Melvin Capital, received a $2.75bn credit line from other hedge funds, Citadel and Point72. Reports suggest that Melvin lost 30% in the first three weeks of January. 

The moral of the story here is that when you open yourself to high risk, be prepared for incurring high losses. It is no ones responsibility to bailout over-leveraged funds. Doing so is called moral hazard, something that we all became particularly aware of during the 2008/2009 bailouts. 

No, this is not driven by fundamentals

There are many investors trying to point to the irrationality of this short squeeze, typically citing the firm's poor fundamentals. True, GME's fundamentals are bad, it's a company that is losing its demand (as players are shifting to online gaming), closing shops around the country, and was particularly hit by the COVID pandemic. After all, the short sellers had to have made some sort of due diligence before deciding to short. The valuation driven by the surge in stock price is surely massively overestimated. But this is missing the point. 

The arguments from the other side citing the potential for improving the fundamentals (with the company planning to shift to the online gaming niche) are also missing the point. This is not about fundamentals. Even if it started this way, with the short-sellers and the early long investors being at odds over their differing opinions about the company's future, this is no longer the point of discussion, and is by no means inflating the bubble. 

This stock in particular is driven by pure emotion, by people that have been hurt by the 2008 financial crisis and are demanding revenge. The reason this keeps going up is that many people still feel that pain and now have a chance to "kick it to the establishment". Sure, there are also speculators out there hoping to make a quick profit and selling at various points in time, but the massive buyers are all those individuals who want to hold this to the bitter end.

This can therefore not be explained by anything we have learned in financial analysis: nor the fundamentals, nor the technicals, not even the standard explanations of behavioral economics like speculative, greedy heard behavior. Sure, this is a form of heard behavior, but not necessarily driven by greed. Especially when many of the investors in the community pledge to donate their profits to charity. Underestimate them at your peril. 

In conclusion, yes, the bubble will deflate at one point, when the hedge funds are beaten and when they start covering their losses (and pull the market down temporarily). A very similar thing happened to the stocks of Volkswagen back in 2008, when the short squeeze made the company briefly the most valued company in the world. That squeeze however was not driven by retail investors, but by Porsche, which ended up with a 75% stake in the VW. What we have today is a slightly different story: the fight of the "little man" against the symbols of the industry. And the little man is winning. 


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