February 22, 2021 – In late January, I wrote about my thoughts on the crazy wild ride in GameStop and some other meme stocks. Now might be a good time to do an update to talk about some of the other things I learned. For example, how a short-interest ratio of more than 100% is surely disconcerting but it’s not quite as scary as it’s often portrayed if you do your math right – which seems to be a luxury good these days!
So, here are some more of my thoughts on the 100%+ short interest, market manipulation, GameStop valuation, and more…
How can the short interest exceed the float?
What made the GME short squeeze so brutal was the fact that the total short interest was extremely high. Even higher than the float! That sounds troubling! How is that even possible? How can that be legal?
Well, it’s relatively simple: Imagine I own 100 shares and my broker lends them to a shorter S1 who then sells them to another buyer B1. Then B1’s broker lends out those 100 shares to yet another shorter S2 who sells them to another buyer B2. We now have 100 (net) shares floating around, but it’s owned by 3 different individuals (yours truly, B1, and B2) at 100 shares each, and it’s shorted by two individuals (S1 and S2) at 100 shares each. Thus, the short-interest is 200% of the float. To my knowledge (experts out there, please correct me if I’m wrong) no law prevents B1’s broker from lending out the shares again. Such a law would even be a huge headache for brokers and investors. If I put in a buy order for 100 shares of some corporation, how do I know how many of them are eligible for securities lending? A lot of institutional investors will definitely prefer the “lendable” shares because they squeeze out a few extra cents through the securities lending option. We’d probably have a segmented stock market where each stock would have two quotes, one for the already-shorted and one for the not-yet-shorted stocks. Sounds like a real headache.
One other insight from this example: if the short-interest exceeds 100% of the float, which sounds mind-boggling and outrageous and illegal, it’s actually not quite as toxic as it’s often portrayed. In the example above, for every short position, there are still 1.5 long positions around (300 divided by 200). Or vice versa, for every long position, there are “only” 0.667 short positions (200/300=0.667).
Most importantly, if x is the short/float ratio, then x+1 is the long/float ratio and thus the short/long ratio x/(1+x) can never exceed 100% no matter how large the x! See the chart below! That x/(1+x) is the ratio that really determines how easy or difficult it is for the shorters to undo their positions. You shouldn’t use the short/float ratio for that! So, again, the short positions as a fraction of all outstanding long positions will always stay below 100% (though it will asymptotically approach 100% as x keeps growing). So, when people are hyperventilating about a short-interest ratio of greater than 100% and this implies that the shorts can never be unraveled it just means people don’t know their math and their their accounting principles. They are likely politicians or journalists. Even at a short-interest of 200%, every shorted stock has 1.5 (gross) long positions that can serve as the potential supply when the shorts have to be undone!
But don’t get me wrong, I certainly agree that a heavily-shorted stocks is something of a landmine. I would not want to invest in it and I wouldn’t want to short it either. I’ll just stay clear of it. But the 100+% short-interest is less of a problem than it’s often portrayed.
Manipulation? It takes two to tango!
And another thought: if you have a stock with 100 shares float and 200 shorts, how can you claim that the shorters are manipulating the market? How about the 300 long positions? Only 100 of them are actual net owners of the stock but 200 additional owners of the share were created out of thin air. Aren’t the 200 extra long positions manipulating the market, too? Only upward? If the 200 extra longs are manipulating the market up and 200 shorts manipulate the market down, wouldn’t it be a wash? Nobody would ever argue that seller of a futures contract manipulate the market. Every contract has one long and one short position! It’s a wash, they net each other out.
Valuation is a two-edged sword!
In response to my post on January 30, a lot of readers pointed out – very correctly – that the origin of the GameStop rally was indeed based on valuation analysis rather than hype. While we can probably all agree on the view that GameStop might have been a bit undervalued at $17 in December and early January, nobody in their right mind, not even Keith Gill, aka DeepF___ingValue, would have seriously argued that the fair price of the stock is $483, the all-time intra-day high in January.
So, what is the “fair value” of GameStop? As always, there isn’t the fair value. It all depends on your assumptions. I’m not an expert on equity valuation (at least not on individual stocks). One well-regarded expert in the field is NYU Professor Aswath Damodaran (the “Dean of Valuation”, see here and here for more info) who put out an upper limit of $47 under the most optimistic assumptions for the future growth of the company (“NYU valuation expert says GameStop is worth only $47 per share, and that’s optimistic“, Feb 1, 2021). And guess what? That’s roughly where we settled over the last few days. So, Professor Damodaran knows his craft! Everybody who got into the GameStop trade at $17 a few months ago (or even better at $3(!!!) a year ago) should pat themselves on the back for their great investing skills. I have never pulled off such an impressive return over such a short horizon!
And if you bought at $300+ you didn’t pay attention to valuation. The irony in all this is that the same force that started the rally of an apparently undervalued stock also hurt the GME lemmings when they bought it at $300+ in January. If you live by the sword you die by the sword! Valuation matters!
The GameStop rally has similarities with Pyramid Schemes and MLM systems
Two observations: 1) People who got in early made a killing. and 2) People who got in late lost a lot of money. Does that sound familiar? It reminds me of the typical “pump-and-dump” or a Pyramid scheme or Multi-Level Marketing setup. Clearly, a few fortunate GME investors that got in early enough made out like bandits, especially if they were savvy enough to have cashed out (at least partially) at the top. But the rise to $300 (even $483 intraday on January 28) was only possible through a growing number of “greater fools” that kept buying even after the stock had already passed any price target that even an optimistic stock analyst would have deemed rational.
Below is a screenshot from a GME investor who lost over $100,000 and is wondering if he/she’s in Valhalla now!? I just hope that most people only bet money they could afford to lose and didn’t gamble money from their student loans! The reddit forum over there is littered with people posting their P&L statements with very little P and a whole lot of L.
We’ll probably never know what’s the win/loss ratio among WSB participants but I wouldn’t be surprised if the distribution is close to the average MLM system where the top 0.1% to maybe 0.5% get rich on the backs of the bottom 99.5%-99.9%.
Also notice that the above screenshot of the person losing $100k+ is undoubtedly from a Fidelity app. So I wonder if this is one of the “lucky” brokerage customers that were still able to buy GME at an average price of $358 a share when Robinhood had already shut down buy orders. Which brings me to the next point…
Where is the gratitude for Robinhood?
The ultimate irony is that all those folks who were shut out from buying GameStop at $300+ in late January are still complaining about market manipulation. Well, if the stock had indeed proceeded to rise to $1,000 by now then I could understand that people are crying bloody murder for missing out on $700 in gains. But shouldn’t the GameStop traders be happy that Robinhood saved them from foolishly buying a stock for $300 when it’s now down to $40? If Robinhood now offered the opportunity to retroactively(!) accept the January 29 buy orders at $300+, how many people would accept that offer? Not even the most delusional “diamond hands” would accept a raw deal like that!
Obviously, the WSB guys and gals will claim that if Robinhood hadn’t shut down buy orders in January then the price could have gone much higher. If we had just let in a few additional greater fools to buy GME at $300 and then $500 and then $1,000 and $2,000, etc., we could have saved the whole thing! Does that sound familiar? Frequently, perpetrators of Ponzi & Pyramid scams will claim that the only reason for the failure was that the government stepped in and shut down the scam. It’s an excuse as old as the Ponzi Scheme itself! Sorry, everybody, but by letting a Pyramid/Ponzi scheme – or an asset market bubble in this case – go on longer we’re not making it better. We only delay the inevitable collapse and expand the number of victims!
Hedge Funds are doing OK!
In Q3 of 2020, the global hedge fund industry had $3,379.6b total assets under management according to this source. Adding $303.6b for CTA (commodity trading advisers) advisers, which are listed as a separate category we get to almost $3.7 trillion dollars.
Side note: The entire hedge fund plus CTA industry at $3.7 trillion dollars pales in comparison with the $100 trillion Asset Management Industry. The number 1 firm in that ranking, BlackRock, is at over twice the size of the entire hedge fund + CTA universe. My old employer (#8 in that ranking) has an AUM over half the global hedge fund industry. So, WallStreetBets (WSB) took on a tiny fraction of a tiny sector in finance.
In any case, the losses due to the short squeeze in GME and other meme stocks are only a rounding error in the January return stats. That’s for the overall industry (Melvin Capital certainly felt a pinch, though!). “Hedge Fund Research” publishes monthly hedge fund return data (even daily for some indices) and hedge funds overall made money in January:
Even equity hedge funds didn’t do too badly. Up 1.12% for the month of January when the S&P 500 was down 1%.
Part of the reason is that the impacted shorters were clearly too small to make a difference in the overall picture. Furthermore, there were apparently numerous hedge funds that made money from the meme stock rally. In this WSJ article on February 3: “This Hedge Fund Made $700 Million on GameStop” if you read the rationale for Senvest Management piling money into GME late last year, it sounds exactly like the valuation story the Keith Gill has been telling on his YouTube channel! Other hedge funds that made money on GME and AMC are also mentioned in that same article.
Can this happen again?
Update 2/24/2021: Well, Murphy’s Law again. Just after I wrote how I doubt GME can stage a comeback, here we go. Another round of the bubble!? GME was up 103.94% today and another 86.92% in after-hours trading. Now standing at $172 again. Let’s see if this lasts!
When you read the news in January, it sounded like we all have to get used to a new paradigm of small investors taking on the big Wall Street establishment. It certainly made for a great media narrative. But the post-GME record of the Reddit group isn’t really supporting that view. Right after the crazy rally in January and emboldened by their recent success, the Reddit group identified another ostensibly undervalued asset: silver. Over the January 30/31 weekend, physical silver dealers, faced with a massive surge in demand, stopped taking orders because they couldn’t gauge the replacement cost of their inventory until the futures market opened again on Sunday at 6 pm Eastern Time. And there was indeed a bit of a rally in silver prices but that fizzled again over the next few days. So, clearly, the WSB group can move smaller stocks over a short horizon, but when it comes to larger targets, I seriously doubt that a Reddit group can move the needle.
So, if you think that the big hitters in the 3+ trillion dollar hedge fund industry are now shaking in their boots for fear of Reddit, I wouldn’t be so sure. The problem with the HODL (=”hold on for dear life”) strategy in the Reddit group is that if everyone is still sitting on their GME holdings, they don’t have enough fresh cash to throw at their next target for a short squeeze. So, WSB really faces a catch-22 now. Should they liquidate the GME holdings to channel everybody’s energy on the next short squeeze target? But that could send GME tumbling even further. Or do the HODL, but then they’d have to wait until the next stimulus check to target the next short squeeze stock. Some of the really smart WSB investors apparently cashed out some of their winnings (DeepF___ingValue among them), so they might try to restart another run of GME or some other stocks. But, again, without enough “greater fools” around willing to blow up $100,000 to find “Valhalla” it’s going to be an uphill battle!
What’s worse, the success rate of any future short squeeze target on the Reddit Group will be greatly diminished because hedge funds are now monitoring the chatter on the site (“Hedge fund job listing wants Reddit traders“). By the time WSB lines up enough people to get ready to buy the next target, hedge funds will already front-run their trades.
Conclusion
As entertaining as the whole meme stock drama has been so far, I’m afraid that the world is a worse place after this. Normally people will learn from an adverse experience. But I fear that people will likely learn all the wrong lessons from this episode! For example:
Valuation: The lesson we should have learned:
“Valuation matters”
but what people likely “learned” from the last few weeks sounds more like
“Valuation matters when GME is cheap. When GME is at $300, we don’t care about no stupid valuation because that’s for boring prudes and dumb index investors. HODL, everyone!!!”
Scams: The lesson we should have learned:
“Beware get-rich-quick schemes”
but what people actually “learned” sounds more like
“Most people didn’t get rich quickly, so we need a congressional investigation into that”
Risk Management: The lesson we should have learned:
“Careful with shorting, leverage, and derivatives”
but what people likely took away sounds more like
“Shorting is dangerous when hedge funds do it. Market manipulation! Maxing out your student loans to buy GME call options is a great retirement strategy, though. YOLO!”
More Risk Management: The lesson we should have learned is that
“if you made a lot of money with an investment, take some chips off the table! (Remember the Kelly Criterion?)”
Some of the smart WSB folks certainly did (including DeepF___ingValue, by the way) but some of the less enlightened WSB investors learned only
“HODL!!! Diamond Hands, everybody!!!”
The “New Economy”: The lesson we should have learned:
“If you get something for free, then you’re not the customer. You are the product!”
but what people likely took away sounds more like
“I want commission-free trades at Robinhood and I deserve impeccable customer service and uninterrupted trading! And mommy, where are my chicken tendies?”
I just hope that we don’t get too much more regulation, higher taxes (e.g., the dreaded financial transaction tax), and a whole laundry list of other nasty political side effects out of this episode! Now that would be a way how the wallstreetbets group could eventually sink the entire financial sector! How ironic that that?
My concern about the greater than 100% short is that it reminds me of the unmitigated leverage of the banks during the GFC. Who cares if one bank does CDOs. But it becomes a problem when everyone is hedging the risk through a single institution and banks can lend without any real capital.
It’s not a problem on 1 meme stock or 10, but it is a problem if it is large enough to cause systemic risk to the system. I don’t think you can unwind or protect that once the short interest is already in place, but you can put in something to prevent it from getting to that stage.
Of course, as you pop one bubble, the bubble/speculation moves to something else. But perhaps it can be something that doesn’t wipe out the global economy and rather just wipes out a specific industry.
I don’t see a valid analogy between leverage and arbitrarily large amounts of short interest conditional on the long-minus-short interest not exceeding 100% of the float (unless you’re talking about brokering a net-short position and thus inheriting the risk associated with clients being unable to pay upon margin call, which I discuss below).
What do you mean by “risk to the system”? And practically speaking, given that shares/contracts are fungible, how could such a scenario be prevented (assuming first that > 100% short interest is actually bad in the first place)?
At a nuts-and-bolts-level, my main concern is that uncovered short positions have unlimited downside and thus are never fully capitalized, so any brokerage with clients with a net short position could potentially wind up underwater in the case that the stock price rises so rapidly that the net position winds up with negative equity before they can margin call the clients; in that case, if the clients can’t pay, the brokerage is liable.
BUT, the foregoing is a problem regardless of the amount of short interest in a stock; it only manifests at the level of clearinghouse participants and does not reflect any systemic issue with the market itself at large. Basically what I’m saying is that this is a real potential problem and it has pretty much nothing to do with the overall short interest across the whole market.
As I mentioned in another comment, brokerages could easily eliminate this risk entirely by requiring short sellers to hedge their positions with OTM long calls and then requiring them to post margin equivalent to the maximum loss associated with the aggregate short + call position. That would imply a huge amount of margin for calls sufficiently OTM such that the client could still expect a significant return on the position but it would at least put a cap on the brokerage’s liability.
Now that I think of it, I don’t think the brokerage’s “net position” is what matters here; I think it’s just the total short exposure. For example, if a brokerage has clients A and B, with A being long 100 shares of XYZ and B being short 100 shares of XYZ, assuming A’s position is settled and the shares are in A’s account, the brokerage still has the risk associated with B’s potential inability to pay in the event of XYZ’s price rising sharply. I don’t think there’s any sort of “netting” here, in the sense that even though the two positions are “net neutral,” the brokerage’s function as a passthrough results in risk that is the sum of the absolute values of the risk associated with each client. It’s just that in my example above (in which I assume that the brokerage has not lent A’s shares to a short seller!) the risk to the broker associated with A is zero because the trade has settled and the shares are “physically” present in the account.
Now what happens if the brokerage actually DOES lend A’s shares? Now the broker has risk associated with the SUM of risk of each position in the sense that they owe 100 shares of XYZ to A and, in the case of B going bankrupt, they owe another 100 shares of XYZ to the clearing entity.
The foregoing is kind of speculative so if I missed anything I’d be appreciative of a correction. I’ve only recently started thinking seriously about this backend aspect of trading.
Most retail trades are actually netted daily so there is less risk. If you have 1 million shares bought and 1.5 million sold, the broker only has a liability for 500k. Brokers can control the flow of trades settling in order to manage their exposure. It may come as a surprise, but there is no guarantee that a trade will settle on settlement date. There are no rules that require a broker to settle trades in order. The broker can choose to hold back settlement if they are in a high exposure situation. Negative net market exposure increases collateral requirements. This is what got RH in trouble, they likely let too many trades settle on one side which drained their collateral at the clearing facility. A well-managed operation would control flow to avoid this. This is why other brokers didn’t have to restrict trading.
As far as shorts/lending, it’s like dominoes. Every action upstream flows downstream and vice versa. Like ER said, every short has a long and every long has a short. You could have 10 brokers lending the same share to each other but eventually, the last short can and will be unwound. It just might take awhile, especially in illiquid market….
Thanks for the background on the trading plumbing issues. I’m not the expert, so I have to rely on folks like you!
And yes, even through there are more longs than shorts, it’s still a headache to unravel the long chain of short/long positions. Good point!
Again: every short triggers a long. There are exactly as many net owners as before. Every shorter creates another long out of thin air.
who get’s to vote all these phantom shares?
The phantom shares don’t get to vote.
I’m not enough of a legal expert but I suspect that only the final shareholder in the chain, the person/entity that never lent out his/her/its shares has the voting rights. 🙂
Are you sure that the phantom shares don’t get to vote? What if they wanted to vote their share, who is going to stop them since they bought the shares? Are the phantom shares they bought not legal shares? Now I see why the Reddit WSB forum is full of discussion about the system being manipulated by Wall Street insiders, hedge funds, short sellers, high frequency trading etc. You can also see how this creation of phantom shares can put downward pressure on stock price and why CEO like Elon Musk and others despise the short sellers. These phantom shares are almost like a company issuing new shares, creating a new supply of stock without receiving and funds if they would’ve issued new shares.
“Are you sure that the phantom shares don’t get to vote? ”
Yes, I am. The brokerage and custodian keep tabs on who can vote and who cannot. Things like this are administered properly and according to the law.
“Reddit WSB forum is full of discussion about the system being manipulated by Wall Street insiders”
I don’t take those discussions very seriously. Even though I’m a Wall Street outsider now.
“Are you sure that the phantom shares don’t get to vote?”
Only in Illinois. But only dead voters and those born before 1850.
oohhh, that’s spicy! 🙂
I’m amazed at the number of political themed ads peppering the post, I guess we’re not quite yet ready for the whole unity thing.
After the election is before the election!
My mention of the the word “politician” and your browsing history will likely trigger all those ads! 🙂
Great analysis; I hadn’t really given much thought to the idea that the short interest can exceed the float even in the absence of naked shorts but everything you said looks right to me. I think the point here is the shares/contracts/etc are “fungible” in the sense that in principle there is no way to differentiate any two shares of the same stock (until they are settled in someone’s account and thus take on a cost basis), so I don’t think it would be possible to identify a particular share that had been shorted as opposed to one that had not been.
I still think anyone putting on an uncovered (not to be confused with naked) short in an instrument with unlimited upside doesn’t quite understand the risk they’re exposed to (XIV, anyone?! The exception might be genuine hedgers like farmers who short sell the crops they farm because they already possess the underlying and thus are guaranteed to be able to deliver). If the folks with the long positions unify they could basically extort the short sellers to an unlimited extent in that they could simply set higher and higher ask prices because the short sellers are contractually bound to deliver the stock. That’s an inherent risk of a short position and the only effective way to deal with it, that I can think of, is to hedge such short positions with deeply OTM long call options which would put a floor on potential losses. Sure you’ll lose the premium but if the calls are far enough OTM that would seem a small price to pay to make maximum losses finite rather than infinite.
Well, there is be a way to distinguish who is who after the fact. The problem is that when you buy new shares you never know which ones you will get.
Yeah, any unprotected short is dangerous. See optionsellers (https://earlyretirementnow.com/2018/12/18/the-optionsellers-debacle/). It would have been better to implement the bearish view through a short stock plus a long call option out of the money as you mention. But that’s an additional cost to the shorter!
1) Very good point about how each short creating a new long. Reminds me of a futures contract. You have one long and one short. Nobody would argue that the short is manipulating the market.
2) Also notice that for a small enough x, the two measures short/long vs short/float are very similar! Most of the time (x<20%) you can indeed use the two interchangeably. But short/float becomes meaningless for a large enough x.
Thanks! Correct, the shorter is very similar to a new futures contract being created. Nice analogy!
I closely followed WSB, got in early and sold out as the price went up. But then I also purchased two calls that were very expensive with the strong conviction that GME would spike to 500+ (where I would have sold the calls). It was a very risky move. Once RH stopped people from buying more shares, price came back down. IBKR’s CEO even said that had it been left unrestricted, we would have seen 1k+ prices. So in short my greed got the best of me and my calls expired worthless.
Wow, you’re brave!
That’s a very common problem: people who initially made money in a “scam” or “bubble” and got out with a profit then get back in again and jeopardize their early gains!
I hope you’re still up overall! 🙂
Re: a potential financial transaction tax. If such a thing came to pass, wouldn’t it severely impair the process by which ETF shares are created and retired? Price could diverge more from NAV because it would be more costly to close the supply/demand imbalance. If so, maybe the larger the ETF segment becomes, the less likely the tax, due to fear of disrupting the markets. Or maybe the government and some Wall Street players will see opportunities to profit, making the tax more likely. Old fashioned mutual funds seem like a safer vehicle.
Regulation to limit high frequency trading could be similarly damaging to ETF investors.
Yeah, a financial transaction tax will have all sorts of unpleasant side effects that people (politicians!) haven’t thought through!
“And mommy, where are my chicken tendies?” haha classic. But you are 100% right, a small percentage got rich off the backs of everyone else. Really just why I am continuing to buy and hold index funds, and sell out of my individual stocks when the market eventually takes a downturn.
Haha, I was debating between “chicken tendies” and “Ma, the meatloaf!?”
What I don’t like is how the attention is now on retail investors. Some lawmakers are now considering taxing people for day trading. What! Yes, while day trading really isn’t recommended and while people shouldn’t be doing it, Gamestop is the reason why they want to tax day traders. To shut out retail investors even more.
I just don’t like this game that we’re playing.
Yeah, very sad. And I’m sure the plans to tax the little guy have nothing to do with GME. The plans to rip us off were in the drawer already somewhere, just waiting for excuse to be pulled out. I hope we can avoid that transaction tax. 🙂
Nice analysis Big Ern! I certainly do hope the politicians don’t mess things up by over-reacting to the GME short squeeze. The nine most terrifying words in the English language are: “I’m from the Government, and I’m here to help. “
Haha, excellent point. The scariest words in the English language indeed! 🙂
Thanks for the info. I was wondering how the short could exceed 100% but as long as there’s a broker willing to lend and debit the stock that make sense.
Your earlier point on the article really makes sense. Time and time again people really fall into mania that repeats itself. The pipe dream of easy money is always the initial lure. A lot of the people on the reddit forum are problem gamblers in reality. I have seen enough posts where ones who manage to make money on high risk trades usually give it all back on the next one.
The irony behind robinhood is that they claim to be catering to serious investors however on their platform you cannot buy into mutual funds but you can buy cryptocurrencies.
Haha, very well said.
RH caters to exactly to the people that customers there. Wouldn’t call them serious! 🙂
Here we go…
https://finance.yahoo.com/news/robinhood-ceo-criticizes-runaway-chain-204611273.html
I.e., the billionaire champion of retail investment and finance democratization is calling for restrictions on the “number of times a share can be shorted.”
Of course, this would make equity markets less efficient because it would place a limit on the amount of participation; specifically, the size of outstanding positions could never be more than 2x (if x is the float).
I don’t believe for two seconds that this guy actually thinks such legislation would be fair/right/just. Less efficient and less liquid markets with wider spreads mean market makers are earning more on a per-trade basis (and in his business of brokering predominantly-long retail trades it probably wouldn’t reduce trading volume). It also means active traders (like hedge funds and prop trading firms) will have more opportunities to identify (and take advantage of) price dislocations from “fair” market value. Clearly, transaction costs and market impact would also increase for active participants and take a piece out of round-trip realized returns but I have a real hard time believing our pal Vlad is acting as the steward of the human financial condition here.
Yeah, it’s not really obvious how you monitor how many times a share has been shorted. Not sure why Vlad floats such nonsense. I guess he wants to raise his status with the regulation-happy folks there…
D’oh…I meant 3x!
Replying so I can received notifications of any new comments. 🙂