A Gamestop branch seen in Munich, Germany on March 4 2021. (Photo by Alexander Pohl/NurPhoto via … [+]
The GameStop Bubble, Updated
The GameStop (GME) eruption has been portrayed as the product of wildly irrational investor behavior – a “frenzy,” a “speculative orgy” (Charlie Munger’s phrase), a “game played by losers who don’t have any idea what they’re doing” – a classic case of the Madness of Crowds.
This view is incorrect. Observers are misled by the fact that the market is obviously not “rational” in the finance-theoretic sense of the term. Share prices no longer reflect the underlying asset-value. GameStop’s mediocre, money-losing business is certainly not 4000% more valuable than it was at this time last year.
But this does not mean that the decisions of the GME traders are irrational.
The GME event is in fact the result of a process that is hyper-rational. It is based on highly accurate calculations of specific outcomes which possess a much higher degree of certainty than is the case for normal investment decisions. There is no “madness of crowds” here. It is a premeditated, predatory take-down of a cornered and defenseless counterparty.
Here’s how it unfolded.
The naive view of the stock market is based on two assumptions that seem self-evident.
This is how we are taught, practically from childhood, to think about the stock market: as a vast convenience store full of investment offerings, all tagged with their respective prices. We are free to wander up and down the aisles, so to speak, to study the merchandise, and decide which offerings are most attractive. We make our own decisions. No transaction is forced upon us.
There are many situations where one or both of these assumptions are invalid.
Many stock transactions are in fact executed without regard to the share price – and are thus also disconnected from any consideration of the company’s fundamental value. Passive index-tracking investment funds do not transmit information about the price/value relationships of the individual components. Michael Burry, the star investor of “Big Short” fame, told Bloomberg News:
When we buy a share of an index-tracking ETF like the SPDR, we are buying all 500 companies in the index, regardless whether they are overpriced or underpriced. When, a month or a year later, we sell that share of SPDR, we are effectively selling the shares of all 500 companies at once. In the interim, some of those companies have surely done better than others, and different components now are overpriced or underpriced. These shifts have no bearing on the decision-to-sell. We are selling them all, indiscriminately, simply because of they are in the index. If a company is added to the index, the ETF managers have to buy it – regardless of price. If it is dropped, they must sell it. Regardless of price. (I have described this process in a previous column, with respect to Tesla’s run-up since November of last year.)
There are several important sources of price-insensitive (and thus value-insensitive) buying and selling, including
JP Morgan has estimated that only 10% of the trading volume in the market today is based on the old-fashioned research-based discretionary investing. The other 90% of the trades are fully or partially price-insensitive. This dilutes the value-related information which the share price supposedly contains – a precondition for a second and more brutal type of market dislocation.
The idea that all trades are entered into voluntarily — which would seem obviously true – is in fact false. There are many situations in which one side of the trade is undertaken under duress, involuntarily and without flexibility of execution. These situations can be exploited by traders on the other side of the transaction who take advantage of the fact that their counterparties have little or no room to maneuver.
A margin call is one example. Investors who have borrowed money to buy shares find themselves forced to sell – at exactly the wrong moment, and at a loss – if their share price falls too far below its collateral value.
Forced selling is familiar. But is there such a thing as forced buying?
Yes. There are several situations in which a market participant has very little option but to buy shares, and often at a highly disadvantageous price. Cornering these forced buyers and feasting off their distress is another one of the ancient arts of the marketplace.
This is the key to understanding the GME event.
Great “corners” of the past – in gold, silver, copper, onions, chocolate – usually failed.
What happened with GME is that the predators (Reddit) figured out how to design a novel and extremely effective corner. They did it by combining, possibly for the first time, two different techniques.
Short sellers sell borrowed shares and hold the cash. They hope for a decline in price, so they can buy back those shares for less than the money they received from the short sale. If the share price rises, their position loses value – because the shares would have to be bought back at a higher price, inflicting a loss on the short seller. There will be a margin call to post more collateral. If the shares rise too much, the short seller is forced to buy back (“cover the short”) at a loss. This forced buying puts further upward pressure on the price – which squeezes other short sellers still holding out. When they cover, at an even greater loss, their buying drives the price still higher. The squeeze can send the price soaring.
This scenario attracts new buyers, the “Longs.” They buy shares that they will later sell to the desperate shorts at the top of the squeeze.
The traditional short squeeze is a slugfest. The Shorts do have a built-in advantage, however. As they defend their position – by selling more – they gain cash. The Longs have to use cash as the battle proceeds.
One of the great short squeezes in recent history involved an attempt by Porsche to take over Volkswagen. Despite the fact that VW is over 10 times larger than Porsche (by sales), the smaller company was able to engineer the squeeze, and acquire a majority voting interest in VW equity. The short sellers were savaged.
Volkswagen Closing Share Prices Feb 2008-March 2009
Intraday trading at the height of the squeeze — Oct 27-29 – was even more extreme, with swings of nearly 100% in a few minutes.
Volkswagen Intraday Prices During the Squeeze (Oct 2008)
The case is extraordinary because of the target’s massive size. As the squeeze played out, VW became (briefly) the world’s most valuable company.
The Porsche strategists added a new wrinkle, secretly acquiring options on top of the shares they owned.
Porsche’s CEO was charged with market manipulation (later acquitted). The leading short-seller committed suicide.
It was a heavy lift to engineer this event. A traditional short squeeze requires a huge amount of ammunition ($$) on the buy-side to corner the short-sellers and force them to cover. Going dollar-for-dollar against the shorts is very hard. Porsche’s move took three years of careful maneuvering. Which is why successful squeezes are so rare. Until now.
The game-changing maneuver is called, obscurely, a Gamma Squeeze. It is a recent invention; if you google the term, there are very few articles older than January or February of 2021. It is clever and powerful. It also uses options to intensify the pressure on the short-sellers, but in a different way.
Here’s a simple example. It starts with buying a Tesla call option. (The numbers are real, as of February 26, 2021.)
If Tesla’s share price rises back to $816, the option is worth $76. The return on your $15 investment is over 500%. (In contrast, if you had bought a share of Tesla at $675 and sold it at $816, your return would be just 21%.)
The “risk/return” relationship is asymmetrical. The downside is limited. The upside is unlimited.
Option Economics – a Tesla Call
But who sells you the call option? What does his risk contour look like?
Your counterparty is almost certainly a market professional with experience in pricing and selling options. The structure of his risk is the inverse of the yours. His upside is limited to the value of the premium ($15 here). His downside is unlimited. If he writes a naked call option, and the price rises, he is on the hook to deliver at the strike price. He will have to buy in the open market – at $816, he would lose a net $76.
Profit/Loss Calculation for Tesla Call Option
Consider the difference this makes in the psychology of the Buyer and the Seller of the option.
The Buyer can view this as a simple wager. He may lose (at most) the $15, but he could win many times that amount.
The Seller can only make $15, and stands to lose heavily if the stock moves up. In effect, he has assumed the same risk as a short seller. Given recent history of Tesla (over $800 just a few days earlier), this is not a risk that a professional would accept. He has to hedge it somehow.
The risk can be hedged in many ways, most of them too complicated to explain here. The simplest is for the seller to buy a share of Tesla at $675 when he writes the option. This is a covered call. His risk of a big up-move is eliminated. (He now has a risk of a downside move, but we can ignore this for now.)
Naked Call vs Covered Call
This transaction is not quite forced – the seller could take the risk and go naked. He could find other ways to hand off the risk by buying or selling other sorts of options. But in most cases writing a call option will trigger someone, somewhere, to purchase of a share of the underlying stock, as a hedge.
The key to the Gamma Squeeze is this: Call options are a much cheaper way to apply the pressure on the shorts. In this example, the option costs just 2% of the cost of buying a full share of Tesla. This tilts the game dramatically in favor of the orchestrators of the squeeze. With just 2¢ of at-risk investment, they can force the shorts to take on $1.00 of new risk. Even with the shorts’ liquidity advantage, this is now a different battle. It opens the game up to the “retail” swarms that mobilized around GME on Reddit. They targeted the huge exposed short positions in GameStop (well over 100% of the company’s outstanding float). Where before it required major financial muscle to even attempt a corner or a short squeeze, now huge numbers of small traders can join the game. The tipping point is quickly overrun. The shorts were forced to cover.
The strategy is hyper-rational because the degree of certainty is very high. Betting on the share price movements based on the ordinary ebb and flow of information in the market is much less certain than betting that buyers who are forced to buy will in fact buy. And if the gamma squeezing trader can position so that the forced buyers have to buy from him… well that is money in the bank.
GameStop is the first prominent example of this novel tactic. The market’s understanding of this phenomenon is still incomplete (which is why so many professionals were savaged). It is not clear how much leverage the Gamma Squeeze adds, quantitatively. Or how repeatable it is. Or how stable – could it break down just as easily with a counter-surge of put options? (Which would exploit the new downside risk implicit in the covered call.) Frankly, I don’t know. But it seems that attempts to execute this technique are growing. The daily volume of options trading in the U.S. has doubled in the last two years. The strongest increase has come from retail traders.
This new squeeze technique constitutes a dramatic example of a more general phenomenon: the structural disconnection of investment decisions from traditional price and value concepts, which can create situations involving coercive asymmetry in certain trading relationships. When buying or selling can be forced, it can alter investor psychology and lead to market dislocations that may be severe.
George Calhoun’s new book is Price & Value: A Guide to Equity Market Valuation Metrics (Springer 2020). Prof. Calhoun can be contacted at firstname.lastname@example.org or Twitter @GeoCalhoun520
My first career: I spent 25 years in the high-tech segment of the wireless technology industry, involved in the early development and commercialization of digital