In the past two days many of us were left slack jawed after an unlikely team of retail investors from the wallstreetbets subreddit successfully short squeezed a number of billion dollar hedge funds on Wall Street. As of last night, the losses stood at over $70 billion!
The truth is that it was a brilliant trade. If it had been pulled off by a billionaire, the mainstream media would be applauding their genius. Instead wallstreetbets have been de-platformed and hung out to dry by brokers.
Why? Because retail investors are the “dumb money“. They are supposed to buy high and sell low. They aren’t supposed to teach themselves options trading strategies during lockdowns and coordinate to squeeze billion dollar “smart money” hedge funds. In this blog we explain the trade and give credit where credit’s due.
Short sellers actively look for stocks that they believe are going to collapse. This could be because of fraud, accounting irregularities, unsustainable business models, or terrible management.
To long a stock all you need to do is buy it. To short a stock you either need to use put options or sell the stock without owning it. How does that work? Well, it’s best explained using an example.
Bear LLC borrows 1 million GameStop shares. From whom? From your low-cost index fund that doesn’t earn enough from fees anymore. Bear LLC agrees to return the shares plus interest after a certain period of time has passed.
Bear LLC believes GameStop will go down in value because they have poor management. So, they sell the shares at say $17 per share. They receive $17 million cash from the sale.
When the shares fall to, let’s say, $13 they buy 1 million shares for $13 million. They then return the 1 million shares to your low-cost index fund plus $500,000 in interest. Bear LLC profits $4 million minus the $500,000 so $3.5 million.
Short selling is not bad. It is an underappreciated but important aspect of healthy financial markets. We should be thanking short sellers for exposing hundreds of frauds over the years including those perpetrated by Enron, Valeant, and the Wirecard and Nikola frauds last year. Not to mention the Subprime Mortgage Crisis.
What happens if the price goes up? Bear LLC would lose money. If GameStop went up to say … oh I don’t know … $454 then Bear LLC would need to buy back the 1 million shares for $454 million, return it to your low-cost index fund, and pay the $500k interest.
Bear LLC loses $454,500,000.
A short squeeze is when one investor buys shares in a stock that another investor has shorted with the intent of driving up the price and causing them to lose money. Why would somebody do that? Maybe one investor reneged on a handshake deal with the other one.
What wallstreetbets did was execute a short squeeze against investors who were short GameStop using a more advanced trade called a gamma squeeze.
Short selling is risky because the upside is limited whilst the downside is unlimited.
If you invest $17 million into GameStop the most you can lose is $17 million if it goes to $0. On the other hand, if you shorted $17 million worth of GameStop shares the most you could make is $17 million if it went to $0. But as we have shown here you could lose half a billion in a matter of days if you were to be squeezed.
What would Bear LLC do if they were being squeezed? The best thing they could do is immediately start buying as much stock as possible as fast as possible. This is called “covering” your short position.
The GameStop squeeze was made extra attractive for two reasons. Firstly, ~75% of the stock was locked up in passive funds that don’t trade. Secondly, the short interest on the stock was 140% meaning that if every short seller needed to cover there wouldn’t be enough stock to go around. Adjusting for the 75% locked in passive funds this created an effective short interest of ~500%. It was champagne in a bottle – ready to pop.
Options are derivatives contracts which give you the right, but not the obligation, to buy or sell a security at a given price at a given time. A call option gives you the right to buy. A put option gives you the right to sell.
Let’s say you pay $10 for the right to buy a stock in 3 months time for $100. In 3 months time if the stock is trading at $150 you are “in the money” because you can immediately buy the stock for $100 and sell it at $150 and make a $50 – $10 = $40 profit. If the stock is below $100 then you do nothing and lose $10.
A put option works the same. Let’s say you pay $10 for the right to sell a stock in 3 months time for $100. In 3 months time if the stock is trading at $150 you do nothing and lose $10. If it is trading at $50 you are in the money because you can immediately buy the share at $50 sell it at $100 for a $50 – $10 = $40 profit.
The cost of an option is linked to the probability of an event happening in the future. Quants like me estimate this based on the volatility of the stock. Options on high volatility stocks like Tesla are expensive because there is a higher probability that the call option will expire “in the money”. There are many flaws in this approach.
Who do you buy these options from? You buy them from market makers. Market markers are firms that make it possible for you trade by always being willing to buy and sell securities. They make money off of the spreads between what you can buy a stock for (bid) and what you can sell it for (ask) not by making bets.
But when a market maker sells you a call option they, in effect, have a bet with you that the stock will go down. To reduce the risk to them if the stock were to go up they can either sell a put option or buy the stock itself. Why? Because if they need to pay you, they can use the profits they will have made from the stock going up.
A gamma squeeze is when you (or 2 million of you) buy a very large amount of short-dated call options in a particular stock. This forces the market maker to buy a lot of that stock to offset their risk.
The market maker drives up the price. The higher the price goes the harder any short sellers are squeezed. If you squeeze them hard enough then some of the short sellers will start buying stock themselves in order cut their losses. The short sellers will cover. This drives the price higher forcing the other short sellers to cover as well.
Here is an example to make it a little easier to follow.
WSB LLC and their 2 million members slowly start buying call options for GameStop for fundamental reasons: it had cash in hand, was solvent, and had too many short sellers.
On 27 Jan 2021 GameStop is the most traded security as everybody buys near-dated call options. The market makers hedge their risk by buying the stock. This drives up the price.
The rising price squeezes the short sellers and one-by-one the short sellers reverse their position and buy GameStop to cut their losses. They drive the price higher and squeeze each other.
WSB LLC sells their call options that are now deep in the money for serious profits.
Just like shorting is not bad, going long a company that has been unfairly targeted by short sellers despite posting surprisingly good earnings and publishing a turnaround strategy is also not bad. In fact, this action by wallstreetbets puts GameStop in a great position to fund their turnaround strategy.
This is not the first time that wallstreetbets has had an impact on stocks. They did similar things with Tesla and Hertz. We can learn a lot from how the activity affected Hertz vs. how it affected Tesla and begin to speculate how it might affect GameStop and other companies that are currently on wallstreetbets radar.
Hertz’s had already filed for chapter 11 bankruptcy and was therefore unable to raise funds through a secondary sale. Tesla, on the other hand, was able to raise $5 billion by selling more stock to the market and is planning to do it again for a total fundraise of $10 billion. Enough to address any concerns short sellers may have.
So, what’s next? Is GameStop going to do a secondary sale to raise money to finance their turnaround strategy? I hope so. Every story needs a good ending. If you want to keep up to date with wallstreetbets I suggest you follow the /r/RedditTickers/ subreddit. The symbols that are trending right now are $GME (GameStop), $AMC (AMC Entertainment Holdings), $BB (BlackBerry), $NOK (Nokia), and $TD (Toronto-Dominion Bank).
Retail investors have always been called the “dumb money“. They sell low and buy high. Furthermore, retail investor activity and margin debt levels have historically been quite good indicators of bubbles.
But … dare I say it … it feels different this time.
Wallstreetbets isn’t what the mainstream media would have you believe. I follow the subreddit and have posted a couple of times. The chats I have had with other members have been surprising. These are young, ambitious, educated, and unfortunately often unemployed or bored individuals sitting at home because of COVID.
Yes, they treat the stock market like a casino. Yes, people have been hurt. But the truth about the GameStop trade is that if Carl Icahn were behind it we would be applauding his genius on TV. We have a hero worship problem in investing. This time around “the dumb money” won and that’s what upset people.
Robinhood demonstrated once again that in the tech world users are second class citizens to customers. They turned their back on the community they helped to create. Yesterday a class action lawsuit was filed against them and, for the first time in a long time, Republicans and Democrats in the US agreed on something.
This was a brilliant trade and we should give credit where credit’s due. You know what they say: “if you can’t beat them, join them” so how long do you think it will take before we get a wallstreetbets ETF to track?