Diamond Hands — The GameStop Saga — Part I
The Covid-19 pandemic fundamentally changed people’s way of life. Unintentionally, it accelerated a growing trend of people taking personal finances into their own hands. By offering commission free trades, brokers opened the floodgates of modern independent investing and trading. Many new brokers appeared on the scene, such as Robinhood, providing easy to use mobile apps with simple user interfaces. They did this all seemingly, free of charge. But the first lesson of undergraduate economics is that there is no free lunch. Everything comes with a cost. Always. Without Exception.
While stuck at home during lockdowns and avoiding virus transmission, a number of people began to research the stock market and trade on these apps. Among them, Keith Gill a former financial educator for an insurance firm and Michael Burry of The Big Short fame, found a discrepancy in the financial market, a mispricing in the share price of GameStop. There is nothing novel in what they did. It’s the same work performed by research analysts at a wide variety of financial institutions. Under the moniker Roaring Kitty, Keith Gill posted his “homework” on his personal YouTube channel as well as on the popular internet forum Reddit under the WallStreetBets sub under the colorful user name “deep — — — -value.” The Reddit forum provided a way to share trading and investing ideas in a much more transparent manner than had been done traditionally. In the past, hedge fund managers and large institutional investors would normally get together in private to discuss ideas. Mr. Gill and others, did so in the public square, transparently.
The Big Short… Squeeze
GameStop was a struggling retailer that many postulated was dying a slow death. The move to online shopping and the death of the mall along with the rise of digital gaming was slowing killing GameStop. Among those espousing this view, were a small cadre of hedge funds and large institutional investors. One such hedge fund, Melvin Capital, was particularly ardent in their views and bet big that GameStop would go bankrupt. It was not a view without merit, but as they would soon find out, not without risk either.
As any lawyer worth their weight will tell you, there are a variety of ways to cash in on bankruptcies. One such way, short selling, involves borrowing stock in order to sell it at a high price only to buy it back at a lower price, pocketing the difference. This is a very risky investment. In fact, it carries mathematically infinite risk. The price of the asset can increase and the investor is on the hook for covering the difference above their short sale price. Now, there are rules and laws in place, to mitigate that infinite risk. Investors must put up collateral, either in the form of cash or other assets, also known as a margin requirement. If the trade or investment continues to sour, more and more cash or assets are required to be put up as collateral. This is known as receiving a margin call.
Melvin Capital and other investors had short sold more shares of GameStop than there were shares in existence. Actually, over 130% more shares than existed.
Whenever the price of a shorted stock rises, it begins to squeeze those investors who short sold it. Because of margin requirements and risk appetites, they are forced to cover their position by buying back the stock to cover their short. This further drives up the price of the stock, creating what’s known as a short squeeze. Short sellers are squeezed out of the market by rapidly rising prices.
To add insult to injury, there was another way to make this short squeeze even more painful for the hedge funds.
Gill, Burry, and others, saw an opportunity.
The Gamma Squeeze
Bear with me, as the mechanics of this are mathematically complex.
There is another way to transact a financial view which doesn’t require nearly as much capital as simply buying the stock. Option contracts provide a leveraged way to transact views. A call option contract gives one the option, but not the obligation, to buy a stock at a certain price by some future date. Similarly, a put option contract gives one the option, but not the obligation, to sell a stock at a certain price by some future date.
Whenever a broker sells an option to an investor, they must hedge the risk that the investor may exercise that option to buy or sell the stock. In the case of call options, the broker hedges that risk by typically purchasing shares of the underlying stock. This is called Gamma hedging which involves solutions to advanced calculus equations. In option contract pricing, Greek letters, delta (price risk), gamma (change in price risk), theta (temporal risk), rho (interest rate risk) and the non-Greek symbol vega (volatility risk), represent risk sensitivities. Financial institutions use these sensitivities to mitigate the risk of transacting option contracts.
As the GameStop trade began to take hold, more and more people began to either purchase stock or call options on the stock. By having to gamma hedge, brokers exacerbated the increase in the price of the stock by purchasing additional shares of GameStop. This created a positive feedback loop.
It all came to a head in the final week of January 2021.
Monday, January 25, 2021
The temperature was rapidly rising on a financial riot never before seen. The prior week had ended with the price of GameStop having rallied 65%. Word quickly spread and everyone wanted in. By Monday, January 25 the trade had become crowded with three major types of player: The original researchers such as Gill and Burry, the “warriors” who wanted to inflict pain on the hedge funds, and the hangers-on who rode the wave of momentum hoping to cash in, as well as a yet unknown number and type of other market participant.
A large part of the warriors were people in their early to mid 20’s that, as youngsters, witnessed their parents lose everything in the 2008 financial crisis. They watched as the institutions got bailed out and their parents didn’t. They wanted to exact vengeance on the hedge funds. They were out for blood (and profit).
The momentum traders represented a wide swath of people. People who were trading in order to pay medical bills, make rent, and grow their savings. Their experience in trading varied widely from neophytes to seasoned traders.
As is yet unknown, there were others crowding the trade. There were unsubstantiated claims of seeing financial advisors and financial professionals in the Reddit forum. Others claimed that hedge funds on the other side of the trade were observing the forums as well.
Late in the day, the hedge funds which were short were suffering badly, including Melvin Capital. Ken Griffin, billionaire founder of hedge fund Citadel, provided Melvin Capital with a temporary cash infusion of nearly $3 billion dollars as their losses mounted. Things for hedge funds would get uglier from here.
Tuesday, January 26, 2021
The price of GameStop continued to climb increasing Melvin Capital’s losses. More and more people were getting in on this trade posting their success stories on WallStreetBets further driving interest. Users warned against “paper hands” which meant selling out of positions and encouraged “diamond hands” which meant buying and holding.
Andrew Ross Sorkin announced on CNBC that Melvin Capital had closed out its short positions, although this was widely suspected by the Reddit forums as propaganda in order to stop the bleeding.
By the evening, a planned, coordinated strike on the hedge funds began to take shape on WallStreetBets and their Discord chat. The band of retail traders would purchase heavily shorted stocks of other companies in order to inflict pain on the hedge funds and profit from it. Each day, they would strike a different company. The plan was to purchase large quantities of shares in AMC theaters on Wednesday and Nokia on Thursday. The crowd planned a hunt and they had their targets.
Wednesday, January 27, 2021
True to their word, the retail traders made shares of AMC climb an astounding 300% on Wednesday morning. GameStop shares were also surging and the gamma squeeze was accelerating putting a strain on the entire financial system itself that many wouldn’t notice until the next day.
The demand for GameStop and AMC were so strong and so fast, it strained on brokers’ abilities to transact and deliver. There were now fewer shares of stock available for them to gamma hedge than existed on the open market, but this would go unnoticed in media on Wednesday. Moreover, the gamma squeeze strained their abilities to pay out the winners. Particularly, Robinhood felt the brunt of this harshly. They did not have enough capital on hand to make good on the trades, violating rules and laws established after the 2008 financial crisis.
In a counterstrike, hedge funds made a coordinated effort to drive down the price of these stocks in order to spook the retail investors out into a mass sell-off. It didn’t work.
The situation escalated even more as during the regularly scheduled press conference for the Federal Open Market Committee (FOMC) meeting, Federal Reserve Chair Jerome Powell was asked about the current situation. Customarily, the Federal Reserve does not comment on individual companies. Retail traders took this as a free pass and continued their strike against the hedge funds.
Behind the scenes however, Robinhood had been allegedly approached by hedge funds and other large institutions to halt new trades in GameStop and AMC along with some other companies. Later that evening, Robinhood sent out a message to its users that they would no longer allow entering into new option contracts. This was the first visible sign of extreme panic.
Thursday, January 28, 2021
The stocks opened very strong. They opened so strong, that investors were looking at a self-perpetuating gamma squeeze all the way up past $570 on shares of GameStop. At approximately 9:58am, the stock had reached $468 in a parabolic move. Two minutes earlier, at 9:56am, Robinhood tweeted that they were not allowing users to buy GameStop stock, but they would allow selling. The trend instantly halted and started a collapse downward, before picking up a bit, after some retail investors were allowed back in.
The retail traders’ coordinated strike was halted.
However, there were unsubstantiated posts on Reddit, which claimed market sell orders had executed at $2,600, and even $5,000 for one user. This meant that the buying was getting to the point of putting infinite positive pressure on the price of the shares. It meant that virtually any offer for shares was being bid.
Gill and Burry were proven correct.
The gamma squeeze had triggered the mother of all short squeezes! The call option sellers (brokers) needed to hedge by purchasing shares. Retail investors were still buying more. The short sellers needed over 100% of their position covered on margin calls. All these together meant that they needed more shares than existed.
In the afternoon, the chairman of online broker Interactive Brokers admitted in an interview on CNBC to not having enough capital to pay out the winners. He admitted to having to shut down buy orders to protect the market. He was not talking about the market for GameStop or AMC shares. He was talking about the entire market. Many brokers aside from Robinhood had very nearly become insolvent based on current capital requirement laws and rules established by the Dodd-Frank Act and international Basel Accords.
In the afternoon, a massive class action lawsuit against Robinhood had been filed in New York’s Southern District. Politicians on both sides of the aisle such as New York House Representative Alexandria Ocasio-Cortez and Texas Senator Ted Cruz banded together to call for investigations into Robinhood and other market participants for manipulating markets by not allowing investors to purchase shares while the hedge funds could.
Even the most vocal opponent of short selling weighed in. Tesla and SpaceX founder Elon Musk commented via Twitter, calling for investigations. His comments sparked massive cheering and support among the retail trading mob.
After market hours, Robinhood allegedly sought a capital infusion of $1 billion in order to meet their capital requirements. They made an announcement that normal trading would resume the next day.
Friday, January 29, 2021
By midmorning on Friday, markets had stabilized, although the price of GameStop and AMC had risen back to Wednesday levels. Trading appeared orderly again and by 4pm when US markets closed, GameStop and AMC closed higher on the day. But the damage had been done and many failures exposed.
At the end of trading, many independent researchers in the Reddit crowd had reported that there was still a large faction of shorts left in GameStop, AMC, and other companies.
Regulatory Implications
It is now widely apparent that Robinhood’s compliance department will be in the hot seat for some time to come. As investigations unfold, many questions will need to be asked. How could Robinhood and other brokers not have had enough capital on hand to meet their requirements? How could some market participants be barred from purchasing stock, but not others?
Other questions surrounding Robinhood’s “free” platform also remain. Robinhood made their platform free of costs and commissions because they sold users’ trade data to the hedge funds. If substantiated in a court of law, this would constitute collusion against the retail traders themselves. The newly resurgent Consumer Financial Protection Bureau (CFPB) will surely need to investigate whether retail consumers were hurt by Robinhood and others actions.
Regulators will also have to come to terms with how they could have allowed more than 100% of a company’s outstanding shares to be shorted. Brokers will also have to reconcile this. Certainly, the conditions which led to this week’s events should not have been allowed in the first place. It is the self-defined job of regulators to ensure markets function in an orderly fashion. Otherwise, there is anarchy.
Apes Together Strong
Throughout the week, many media pundits questioned whether this would blow over quickly and things would return to normal. Early on in the week, I had this feeling deep in my gut. I had seen this before.
As someone who grew up alongside the internet, not within it, I witnessed a certain psychology emerge in the mid to late 90’s. As the internet was coming of age, music piracy exploded. Congressional hearings occurred with Metallica front man Lars Ulrich as he sued music downloading app Napster. Eventually, Napster was made to acquiesce to lawmakers’ demands. But as one piracy platform closed, others proliferated. Piracy was here to stay. Even all these years later, it is unabated. That moment was a paradigm shift for the music industry.
The rise of the retail investor follows a similar psychology and paradigm shift. As with 90’s music pirates, retail traders’ mantra is, “you may stop this individual, but you can’t stop us all.” If that line sounds familiar to you, that’s because it is the final line in the Hacker’s Manifesto originally published in 1986. Like hackers, like music pirates, retail investors are not going away.
Traditionalists’ illusions will slowly shatter. The democratization of investing is here to stay.
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