Some interesting perspective yesterday from Forbes with the article “GameStop/Gamestonk” Has Nothing To Do With The Madness Of Crowds.
I’m going to pick out some of the sections that really called out to me. Feel free to read the whole article in the link above.
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.
The Short Squeeze
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.
The GME Gamma Squeeze
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.)
- On February 26, Tesla closed at a price of about $675 a share
- 2 days earlier Tesla had closed at $742; 2 weeks earlier it was at $816 – so you think it might go up again
- You buy an option to purchase a share of Tesla for $725. The option expires in 2 weeks, on March 12
- The option costs $15
- If Tesla’s price rises above $740 ($725 plus the $15) on or before March 12, you make money
- If the option expires on March 12 and the stock is still below $740, you lose $15
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.
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.
In all, it’s a pretty thorough review of the current situation. I think many people on Reddit take offense at the description of “predatory” but for many of the Reddit Army, it feels like finally being able to play the game the hedge funds are used to already doing.
Hopefully, this article helped show that the GameStop event is no just madness of crowds.
If you really want some more info, check out this website: Admittedly, it can sound like a conspiracy theory at first. As always, do your own due diligence and make your own decisions.
In the meantime, if you are ready to get off of the sidelines, set up a FREE consultation with us here: