Update (February 8, 2021): Well, there you have it, GameStop is back closer to reality at around $60 as of today. It lost 80+% from the peak value. Who would have guessed that?!
January 30, 2021
Wow, what a week! I was reminded again why I prefer to be an index investor (for the most part). I don’t have to live through the wild price moves as we saw in GameStop (GME) and the other “meme stocks”. And I don’t have to worry about trading restrictions. But it was entertaining to watch the drama, stocks going up by 100+% in one day and seeing short-seller hedge funds being driven to the brink of ruin. The media certainly loved this story of David vs. Goliath; a mob of Reddit users in the “Wall Street Bets” (WSB) group vs. the powerful finance establishment! My blogging buddy Retire in Progress wrote a nice post about the GameStop Short Squeeze. But I also wanted to share some of my own thoughts. Let’s take a look…
What created the price spikes?
Before I get started, let me just briefly go through some of the basics of how we can generate such crazy price movements. What we observed here in the case of GME, AMC, and several other meme stocks is called a short-squeeze. Investors who short a stock can’t just sell out of thin air. They first have to “borrow” the stock from someone, normally a brokerage company that lends out the shares of some of their other brokerage customers – a process called securities lending. To return the borrowed stocks, the shorter will then have to buy the shares back at a later date.
Also, a quick side note: to borrow the shares, the shorter will have to pay a fee to the lender. So, if you ever wonder how brokerage companies can offer you free brokerage accounts, commission-free trades, etc. that’s part of where their revenue comes from!
A short-squeeze is essentially a self-fulfilling prophecy where due to a price hike in a stock with a lot of short interest, the shorters have to then scramble to buy back the shares they borrowed and this “panic buying” then puts even more upward pressure on the price. Of course, someone with infinitely deep pockets could theoretically just sit out the price spike but nobody I know has infinitely deep pockets. As the adage goes: the market can stay irrational longer than most investors can stay solvent. This has ruined many investors that would have been correct in the long-term, but got wiped out through margin calls in the short- and medium-term. LTCM, MF Global, are famous examples and also smaller players like OptionSellers (see my case study) and many more.
An additional factor in the price spike was that the WSB crowd got their bullish exposure to the underlying stocks not only through buying the stocks outright but primarily through buying call options on the stocks. A call option is a derivative that gives the buyer the option (not the duty) to buy an asset at a given price in a given time window or at a certain point in time. As in every derivatives transaction, it takes two to tango. For every buyer of a call option, there has to be a seller of that same option. Very few investors will sell a naked call because the loss potential is truly unlimited. Most will “delta hedge” the exposure of the short call option. So for example, if you sell one call option (100x multiplier) with a Delta of 0.2, you’d hold only 20 shares of the underlying to hedge the risk of (short-term) price movements in the underlying. That way, if the price of the stock goes up by $1, you lose 100×0.2=$20 and that loss is exactly offset by the $20 gain in the stock portfolio.
Unfortunately, delta hedging is not a one-time set-it-and-forget-it affair. As the price of the underlying changes so does the Delta (also called the Gamma effect), so the Delta-Hedging has to be readjusted, most often daily. And if the price keeps increasing, so does the Delta. It means that the investors with the short call option were forced to buy more of the underlying every time the stock went up to Delta-Hedge their short call risk. So, the price going up begets more buying pressure and thus the price will go up even more. It’s an upward momentum machine that exacerbated the buying pressure from the short-squeezed funds even more.
Let’s move on to some of my thoughts…
The rumors of “Big Wall Street’s Demise” are greatly exaggerated!
Is Wall Street finished now? There were some lurid headlines like “GameStop Moves Show How Individual Investors Are Shifting the Wall Street Power Dynamic“; I had to laugh at such a dumb headline though it was sad seeing it in the normally reputable Wall Street Journal. Sorry to sound like a party pooper, but Wall Street is quite a bit bigger than the handful of short-bias hedge funds that faceplanted recently. Everybody, myself included, loves a David vs. Goliath story, so just to be sure, I couldn’t help but feel a bit of Schadenfreude myself. Especially because I can’t say I even know anyone personally who works in the space of short-bias hedge funds, despite being active in finance for 2+ decades. That alone shows me what a niche market this is in the grand scheme of the finance world. If these Reddit investors want to impress me and seriously take down Wall Street, why don’t they try to move the S&P 500? They probably couldn’t move the market by even 0.01%. The market cap and the daily volume in physicals, ETFs, futures, futures options, and index options is a bit too large for their budget consisting of a stimulus check and mommy’s allowance. So, I think the media got a bit too far ahead. In case you didn’t know already, Wall Street will survive this! 🙂
Update (2/8/2021): Sure enough, the HFRI Index data shows that the overall performance of all hedge funds was positive (+0.92% equal-weighted, 3.38% asset-weighted). Equity-centric hedge funds were up 0.78%. Recall that the S&P 500 was down 1% in January. Market-neutral (where you’d likely find a lot of the shorters) was down 0.53%. But a far cry from what was portrayed as WSB sinking the entire Hedge Fund industry!
Wall Street in general and Hedge Funds in particular might even be net beneficiaries of the market volatility!
If you thought that there’s a lot of animosity between the WSB crowd and hedge funds, keep in mind that the only group of people with even more intense hatred toward hedge funds are, you guessed it, other hedge funds and Wall Street players. If you remember the LTCM debacle in 1998, LTCM reached out for help to some of the Wall Street heavy hitters. As the rumors go, after seeing the LTCM positions, some of the firms apparently used that knowledge to bet against the LTCM book, accelerating the fund’s demise. So, I wouldn’t be surprised if other hedge funds jumped on the GameStop bandwagon some time ago and profited from the short squeeze after they saw some of their Hedge Fund “friends” get into hot water. So, all the talk about Reddit taking on the big Wall Street Goliath may look like a great narrative. But there are some brilliant and savvy people in finance, and I suspect that they already benefited from the short squeeze after sensing blood in the water, making more money than all the WSB folks combined. The same thing happened many times before: LTCM, Lehman Brothers, etc.
Furthermore, I wouldn’t be surprised if there are already some high-frequency fund algorithms monitoring the Reddit group to identify the next stock going to the moon for no fundamental reason.
In any case, we shall see how the hedge fund world performed in January; a company called Hedge Fund Research (HFR) publishes aggregate hedge fund return indexes regularly. I doubt you will even see a blip in the performance of the headline index when the numbers come out next week.
Other non-hedge-fund establishment finance players also made out like bandits. A private equity company holding AMC convertible bonds had a huge payday, see the WSJ article here: “Silver Lake Converts AMC Debt to Equity After Dazzling Stock Rally“.
I would also suspect that some of the non-hedge-fund players on Wall Street might have done very well. More trading volume is generally good for Wall Street revenues. I wouldn’t be surprised if some of the Wall Street heavy hitters had a record January profit thanks to the Reddit folks and the useful idiots in the media.
Update 1/31/2021: My blogging friend Retire in Progress provided the following interesting link: Nine Investors Instantly Make $16 Billion On GameStop Stock ‘Squeeze’ confirming some of my points. Among the nine largest (estimated!) GME stock holders are mostly the large fund companies (Fidelity, Blackrock, Vanguard, Dimensional) and a few professional investors. Apparently, passive index investors got the largest share of the gains followed by a few other establishment professional investors.
Update 2/3/2021: WSJ article about hedge funds that cahsed in on GameStop.
The smart short-sellers had probably cashed out of that trade already!
Let’s look at a chart with a long history. As recently as October 2015, GME was trading at about $47 before the company’s long demise started. If you are a smart short-seller who shorted GME at $47 and saw a quote of $3 in early 2020, why would you want to keep sitting on that short position after you made $44? You already made 90+% of the potential profit, why not get out at that time? You’d hope that the smart short-sellers did. And the late-comers and the greedy ones and the incompetent ones wanted to squeeze out the remaining $3 of potential profit by seeing the price go to zero. A bad idea! So, again, a few short sellers tried to pick up more nickels in front of the steamroller and got – well – steamrolled. But I don’t think that this will put a dent in the financial market in general or even the hedge fund market in particular.
The success of the “Wall Street Bets” group is likely exaggerated!
I’m glad that some of the WSB traders got rich. So rich in fact, that they’ll be able to pay off their student loans, see here: “Redditor betting on GameStop claimed to use profits to pay off student loans” (from Yahoo!Finance). Congratulations, you’re now just as rich as I was when I finished college and the economics Ph.D. without any student loans! A little bit of sarcasm here, sorry! But seriously, I am elated that taxpayers (i.e., most of us here) don’t have to bail out a bunch of Gen Ys and Gen Zs now. And once they file their taxes next year and they see the big bite from paying the full tax rate on short-term gains (federal plus state) plus potentially Obamacare taxes, I sense that they will learn an important lesson. We should all celebrate that.
But I also wonder how many of their bets before GameStop, AMC, etc. have not panned out so well. If they have been playing this kind of game, i.e., buying deep out of the money call options on some dead-beat stocks and waiting for the recovery, I sense that they must have blown through a lot of cash before hitting the jackpot in late 2020/early 2021. That’s because if you buy a call option and the price of the underlying stays below the strike you get nothing. You lose the option premium. A 100% loss relative to the price of the option. So, you will obviously hear from some of the loud members of the WSB group holding up their bounty, but for every one of them, there are probably dozens of less successful traders. See Omar’s story in the recent CNN post.
Was there discrimination against retail investors?
Brokerage companies, especially Schwab and Robinhood, took a lot of heat for restricting trading in the “meme stocks”. Even my blogging colleague Paula Pant proclaimed that FIRE folks and the meme traders should now be “united under a common banner” to demand trading for the people. Though I hope Paula was a bit sarcastic about that one, because my support for WSB is certainly limited. The way I understand it, trading was restricted only for the handful of meme stocks and only in one direction (buying). On Wednesday, Thursday, and Friday, I traded CBOE S&P 500 index options in my Interactive Brokers (IB) account and single name stock options in my Fidelity IRA, all without any glitches. So, I don’t quite understand what the hubbub is about.
The trading restrictions were construed as more evidence of the “us vs. them” and the “people vs. the powerful” narrative because it gave rise to rumors that individual investors were shut out to protect the rich and famous and the powerful hedge funds. I don’t quite follow that logic. If you had been a hedge fund trading with Robinhood you would have been restricted just like everyone else (yeah, I know, no hedge fund will ever trade with Robinhood). Likewise, if you had been a retail investor trading with a Prime Brokerage where hedge funds tend to hold their accounts then you would have faced the same restrictions (or lack thereof) as the hedge funds. You get what you pay for. And since you pay nothing for your Robinhood trades you occasionally get exactly that: nothing, i.e., no trading access. Get over it! In a few weeks, when the meme stocks have fallen back to a normal level again, you will all be happy you didn’t buy GME call options with a $500 strike!
Update 1/30/2021, 11:50 am: As some readers have pointed out, it looks like the trading restrictions were not even that intentional. They had to do with the fact that in light of the extreme volatility of some of the stocks, the clearinghouse (Apex Clearing) used by many of the brokerages was forced to put up more collateral to clear trades but was not able to. See the relevant WSJ article. It would explain that retail clients at other brokerage firms had not faced restrictions at all. Again, this doesn’t appear like a targeted attack on retail clients. If you’re a hedge fund and your broker had used Apex you’d have faced the same restrictions. If you’re retail client using the “right” broker you had no restrictions.
Did the short-sellers manipulate the market?
Short-selling is an essential tool in finance. If you are a stock picker and you perform securities analysis you should have the right to short-sell the stocks you find overvalued, just like you have the right to buy the stocks that you feel are undervalued. In fact, the price-finding mechanism should normally function more efficiently if financial actors can short the stocks they find unattractive. Well, I say normally because the Reddit crowd has just established an exception to that rule, at least in this handful of instances out of a pool of thousands of stocks. In any case, unless the short-sellers spread false information about the stocks they just shorted (also called “short and distort” – essentially the inverse of “pump and dump”), then everything is perfectly legal. A lot of the short-squeezed stocks I studied do indeed look like corporations with extremely weak fundamentals and a very uncertain outlook, measured by very objective criteria, like EPS, EBIT, EBITDA, cash flow, etc.
Of course, where it gets a bit questionable is when the short-sellers’ analysis is blinded by their own economic incentives. And instead of just passively sitting back and waiting for the bad stocks to go under they go public and bash the stocks they short. Where does objective securities analysis turn to biased analysis and ultimately misrepresentation and securities fraud? Probably the funds that shorted GME never crossed the legal definition of fraud. As a general rule, I always ignore people pushing an agenda and that goes for both the shorters that are bashing stocks as well as the people with long positions trying to push the stocks higher.
Did WSB manipulate the market?
Likewise, the WSB people totally have the right to buy call options on whatever stock they like. We can’t even call this “pump and dump” because the Reddit group seems to be quite transparent in that they never claim that GME is a great stock worth $300+. They just want to squeeze the shorters. You can’t be more transparent and honest about your motives for being short-term bullish about a long-term pathetic stock. That doesn’t look like manipulation at all!
Which of the two sides is the smaller evil?
Politicians are getting involved now. Oh, my! And both congresswoman Alexandria Ocasio-Cortez and Senator Ted Cruz are agreeing on something and siding with the retail investors. We should all be worried now!
Just to be sure, I don’t particularly care for either side, neither the short-sellers nor the WSB group. If I had to side with one of them, though, I’d probably still go with the short-sellers as the slightly smaller crooks. So, a (temporary) restriction to buying the impacted stocks, as troublesome as it may have been, was probably for the greater good. There are (at least) two reasons why I think the hype and the price surge about WME and some of the other short-squeezed stocks is actually very counter-productive:
First, one could argue that some of the short-squeezed stocks became so unlikable because of past management mistakes. For example, in the gaming world, everything has been moving toward downloads and games on handheld devices. The demise of GameStop is likely due to past and current management sleeping at the wheel and not recognizing this trend (anybody noticing parallels with Blockbuster Video?). What kind of signal are we sending when potentially ineffective and incompetent managers get rewarded and see their own call options skyrocket? In other words, if you think that the retail investors in general and the WSB group, in particular, are the biggest beneficiaries of this price surge, think again. Management of the impacted companies, past and current, will likely hold a much bigger chunk of the long call options than a few Reddit kids who gambled their stimulus checks. The Wall Street Journal reported about this issue: “Insiders at GameStop, BlackBerry, LaCroix Maker Are Suddenly Sitting on Big Stock Gains“. WSB might have just shoveled millions of dollars to the incompetent managers that drove some of these companies against the wall. Great job, everybody! It’s like Robin Hood (and I mean the guy in Sherwood Forest, not the broker) taking from the rich and giving the loot to some other rich person, only a completely incompetent and less deserving one. Not fair!
Second, pushing the share price higher is counter-productive because for some of the “zombie companies” that are potentially unsustainable in the long-run, being taken over might have been the only route for long-term survival, at least for part of the business. Well, I guess at a market cap of $20b we will not find a buyer for GameStop anytime soon. In the worst case, we might even see some of the “zombies” raise some fresh capital now and they’d take over a healthy company. Good luck with the new management! Turning capitalism on its head!
There you have it. As I said in the beginning, as a (mostly) index investor I don’t have a horse in the race here. Except for the integrity and stability of financial markets at large. Restricting retail investors from buying the impacted stocks was troublesome in one sense but defensible in another. It was certainly a PR disaster for brokers and potentially the green light for politicians to come up with more cockamamie financial regulation. Not happy about that!
So, in any case, I just wanted to point out some of the not so comfortable and not very popular viewpoints you might not have heard elsewhere. With the general public, the media, and politicians (both parties!) and even personal finance bloggers, all ganging up on the finance industry it almost feels like the latter is now the David fighting Goliath. How ironic is that?