It seems like we cannot go a day without seeing or hearing about the GameStop saga! It undoubtedly has been a bit of a Groundhog Day scenario with either the media blasting the story, or, if you are as fortunate as me, having every Uber driver express their unsolicited amateur-gone-professional trading opinion. Nonetheless, it goes without say that the story and the events that unfolded are truly a once-in-a-lifetime event. And while I have been hesitant to add more opinion to the already over-discussed topic, I did want to take a moment to address some of the enraged backlash that manifested after a popular robo-trading brokerage, Robinhood, restricted the buying of certain securities. As we know, there is always more to the story. My aim today is to provide an explanation of the inner workings of what happened to the price of GameStop, and how the aftermath of restrictions on brokerages was not as nefarious as it seemed.
First and foremost, I tip my hats to the retail trader for taking financial freedom into their own hands. I am glad to see many individual investors find excitement, curiosity, and intrigue around financial markets. In truth, our aim to start Delos Capital Advisors is not all dissimilar as it was to help bridge the gap between the retail and institutional markets by democratizing financial planning and investment strategies. And while financial markets have many flaws, the more participants in the aggregate, the more efficient the financial markets hopefully become. But of course, from time to time, we get to experience an amazing market inefficiency which lead to outsized volatility, and hopefully some serious profit taking. The latest…. GameStop.
To begin, we must first understand the premise behind the meteoric rise in GameStop. As you may know, many retail investors massed together via reddit/WallStreetBets to create a short-squeeze and did so successfully I must add. Short squeezes have been a common investment strategy employed by investors for quite some time. While there is still speculation regarding the true origin date of short squeeze, most practitioners familiar with the strategy look to the early 1900s of Piggly Wiggly. Piggly Wiggly was a chain of retail stores that began facing bankruptcy issues as many of their expansion efforts showed signs of financial instability. Once Wall St. got word of the economic trouble, many investors found the company to be a viable short candidate.
As a sidebar- a short position is when an investor BORROWS (very important to remember this*) the stock they are willing to bet will fall from their brokerage house (think Charles Schwab or Robinhood). The brokerage house goes out and finds an investor who owns the shares of the respective stock and is willing to lend their shares to the investor that is wanting to take a short position (investors makes money on lending their shares like a low interest rate loan). The investor wanting to short the stock has now borrowed shares from the investor who is long the stock (owns). Our short investor now sells the stock and collect the proceeds. The important takeaway is that since the investors has borrowed the shares and sold them, he must buy them back at the prevailing price. So... the short seller needs the price of the stock to fall as he must buy them back once he wants to realize his profit. The profit is determined by the proceeds collected less the proceeds needed to purchase to stock back. Remember, the investor must purchase the stock back to realize a profit (or loss) as he or she must deliver the stock to the investor they borrowed from. This is where short squeezes come into factor.
From time to time, short squeezes occur which is what has happened with GameStop. And how the occur, especially of this magnitude has a lot to do with supply and demand dynamics of stock that company has trading in the market. For example, in our previous statement, the short seller has borrowed XYZ number of shares to sell short. Well, we must remember that companies only have a SPECIFIC number of shares (stock) trading in the market (this is known as equity float). Therefore, from time to time, you get a situation where more investors become short sellers than there are long (buying) investors. When this occurs, activists’ investors like hedge funds, use tactics to incite a short squeeze which forces these short sellers to repurchase the stock as the price rises. So, if the stock price rises faster (because more people are buying the stock) the bigger the loss becomes for the short seller. In sum, the short seller is literally squeezed because there are now buyers than sellers trying to force the stock higher.
Now, the occurrence with GameStop centers around the fact that it was one of the most heavily shorted stock in the index with 140% short interest as a percent of equity float! In layman’s terms, that is a ton of short selling!! And the fact it is over 100% means the short selling was being done on margin (debt)! Buyers and sellers (short sellers that is) have the ability to borrow money from brokerage houses to enact their investments. This is done to amplify returns as you are borrowing house money rather than your money to place a bet. See chart below-
So, it is quite ingenious, of any investor to take advantage of short squeezes as a strategy given the profound ricochet that occurs as short sellers are FORCED to unwind. Therefore, we’ve seen not only GameStop go crazy, but Bed Bath and Beyond and AMC Networks. Why? Because they have the highest short interest as a percentage of float. See chart below-
Now where the petrol ignites the situation is when investors use option contracts (investment vehicles used for hedging or speculative purposes that derive the price from an underlying investment). Option contracts contain embedded leverage based on the nature of their structure and the derivation of the price from the underlying investment. Robinhood traders, amongst other brokerages, where using option contracts to amplify their returns thus in turn throwing gasoline on an already stoked fire. This is known as a GAMMA squeeze. A gamma squeeze is like a short squeeze but takes it a step further to reflect additional stock purchases due to open option contracts. Remember, options are an investment instrument used to hedge or speculative bet on the underlying price of the option. In sum, the more open option trades that occurred, the more stock buying that needed to occur. The best way to explain this is in the chart below from SentimentTrader-
In sum- GameStop contained the highest short interest on record; a smart investor realized a short squeeze was ripe; a smarter investor realized you could create a GAMMA squeeze by using option contracts to force more purchasing. But what investors needed to realize was that short squeeze creates volatility that pushes the price of the stock way above its intrinsic value. This causes quick price drawdowns as investors begin to take profits and force the stock back to fundamental values. This creates a very expensive round-trip trade if you do not exit at the right time or creates immediate losses if you’re too late in buying. This is the risky cycle of short squeeze strategies. A recent example is Volkswagen in 2008-
And lastly, AND THE MOST IMPORTANT, is the situation with Robinhood as it is not all as nefarious as it seems. Yes- Robinhood should have notified investors of their actions (restricting buying) and WHY they took those actions. BUT their actions are justifiable, as Robinhood is a newer brokerage firm with an average account size of $1,000 to $5,000. Majority of those accounts facilitate speculative option trading, as we discussed earlier in our GAMMA squeeze conversation. Now as I mentioned, option trading has inherent imbedded leverage which makes brokerage firms much riskier to the clearinghouses as a) option trades are risky and b) cash settlement does not occur simultaneously.
As a side bar- clearinghouses are financial institutions formed to facilitate the exchange of payments for investment assets. And payments, just like our debit card, process but don’t post for a few days.
What happens is that the clearinghouses begin to demand collateral from the brokerages given the amount of risk the brokerage arm is taking. THIS IS NOTHING NEW. Commodity traders, future traders, and options traders have all had to pony up collateral to maintain their speculative trades and have done so for DECADES. Therefore, the clearinghouses demanded Robinhood to raise collateral as majority of their accounts were engaging in speculative options centering around a speculative strategy such as a short squeeze. This collateral call comes at a time
when margin debt is at all-time highs. This is a significant risk to the system. And let me be clear, Robinhood isn’t the only one that was subject to margin maintenance/collateral call during this GameStop Extravaganza. The reason they had to halt trading was because their average account size is dramatically smaller than a large and older institution such as Charles Schwab that maintains much higher cash balances. This is what created the forced liquidation or a sell only situation.
The best example I can give that hopefully most people know is from the movie Trading Places. Luis and Billy Ray make speculative bets in Orange Juice thus forcing Mortimer and Mortimer (the brokerage firm) to get squeezed. In the end, they lose their firm because they did not have the collateral to maintain their risky trade. Obviously, there is more to the plot but hopefully you get the gist
I hope I was able to keep this as high-level as possible. The main takeaway is that short squeezes are a risky strategy that are meant to extort a price appreciation. As you saw from our VW example, they are short lived and require precise entry and exit points. Furthermore, while it is great that retail traders were able to conduct one in a lifetime distortion in the market, the brokerage house (given their relatively small size) was subject to regulation that is put in place to protect investors; maintenance of debt and risk. With that being said, it is the fiduciary responsibility of any brokerage to discuss the nature of investments and risk associated.
I hope this helps explain, at a high-level, the inner workings of how GameStop became a world-renowned trade.
Sincerely,
Andrew H. Smith Chief Investment Strategist andrew@delosca.com asmith971@bloomberg.net
