Let’s talk about GameStop, Reddit, and the Stock Market $GME - Part 2

Ok, so GME went CRAZY again… Yesterday it closed at about +104% and almost doubled that during after-hours. I mean, at some point, it even hit a peak of ~ $189 from the $40-50 that it had been trading for almost 3 weeks now. Like I said, CRAZY.

But why?

Some say it’s due to the resignation of the CFO amid a strategic change of directions, others say that it’s in reaction to Charlie Munger’s comments, and others say that they just bought it because #ILikeTheStock #ToTheMoon… I have to say that it is possible that a second “mini” squeeze is responsible for this. After all, the short-interest held at about 40% of the float for a while now changing only these last few days and it’s possible that some inside information tipped some traders that the shorts were resuming their short position thinking the Reddit frenzy was all over.

None of those explanations are really satisfying.

I agree. They all have their issues and I think they’re all mostly wrong but also a little bit right. We’ll get into it in this article but before we do that, I have to say that this is just part 2 of a 3-part series.

Check them all here:

1.    The Concert (for the n00bs) – basic concepts

2.    The Second Coming (for the #WannabeTraders) + The Addendum – detailed financial aspects

3.    The Aftermath (for the dense) – philosophical discussion

Now, let’s begin…

Part 2 - GameStop’s stock the second coming, but not for the n00bs!

Yesterday (and maybe today) is going to be another day that will be remembered for a long time.

As I write this, GameStop (ticker symbol $GME) is now a ~ $10Bn company, sitting at the metaphorical table with the likes of Western Union, Kohl’s, and The New York Times. (Well, let’s not forget that about a month ago, GMA was sitting at the ~ $24Bn table with the likes of Kroger, Deutsche Bank, Beiersdorf, and Telefonica, so… who knows what about what?)

A company whose stock was worth ~ $3 a year ago, later went to ~ $350 in a matter of weeks, and then went back down to a pseudo stable $40. That stock is now worth ~ $140. Meaning that you could have made almost 29000% of your money if you rode both waves fully investing all of the proceeds of the first one into the second one (about 11.5K% in the first and about 250% in the second). And that’s without any margin!!!

Buuuut we’re in the now, looking at our screens seeing the stock worth about $140 [EDIT: $124.6 at time of publishing] wondering about what to do…

Is it gonna go up? Is it gonna go down?

Before we make any call, we must remember that some things have direct physical value, like food when I’m hungry or a boat if I need to cross the river (or go to a regatta in Greece #HECforlife). But a whole lot of other things only have value because we collectively agree that they have value… No, really. Even money and gold and the Kardashians. Most “value” in the world spawns from and is maintained by our collective imagination.

Confusing “price” with “value”.

Well, yes. Many people do that, and my previous statement might actually suggest that I did that. But hear read me out.

On the one hand, we have GameStop, with negative earnings and a wish of a strategy that might not succeed. Is this company worth $10bn? Probably not (we’ll get to that). But on the other hand, there are people out there selling GameStop shares for real dollars at $140 apiece! So, who’s right?

Like everything in life, both and neither. WTF? Well, some of you might immediately say that the first part is related to the “value” and the second to the “price” (or even “implied price”). The thing is that for the person selling the stock, that price is what’s providing them with value. They don’t buy the stock to earn interest or projected free cash flows. No, they buy the stock to sell it at a higher price. Let’s go to an example…

Say that someone buys $1Bn worth of TSLA. What’s gonna happen to the stock price? It’s probably expected that the price of Tesla stock is going to increase by more than 1Bn/700Bn = 0.14%... Why? Well, because when someone bought those shares, the price of EVERYONE’s shares also increased, not just those that were sold. If some of the holders feel that they want to sell at that increased price, they can choose to do so and that might affect everyone’s share price, not just their own. What does this mean? Simply, that if the market says that TSLA is worth ~ $740, then it means that the buyers, the holders, and the sellers met and agreed that TSLA was worth $740 per share (and not floating stock remained the same – i.e. Elon didn’t sell). In other words, this means that even though no one would really pay $700Bn to buy TSLA, most of the players involved still agreed that it is worth $700Bn. But why?!? Because they see where it was, and where it is now, so they project where it might be. That’s it. But it’s as much about pricing as it is about valuation. Why does this matter in the case of GME? Well, because the size of the float, the daily volume, and the structure of the orders amplify everything. In GameStop’s case, it only takes 50 GME shares on average for every active r/WallStreetBets member to account for half of the float (or just 5 on average if we consider all the subscribers instead). This not only means that 50% of the GME stockholders would have to account for the selling pressure in order to keep the price stable (assuming all r/WSB stockholders are only wanting to buy or hold) but it also means that most of the orders are going to be small market orders on one side of the equation because the daily volume is about 78% of the float. This is all a recipe for violent price swings #SupplyAndDemand.

Let’s go back to the valuation

Taking the best-case scenario: GameStop sales recovering quickly in 2021 to close to 2019 levels (that’s a 50% increase btw) and growth from online sales more than making up for the fewer stores. Additionally, in this scenario, the new strategy works and margins move towards the online retail average. (Also, I have to assume that the ratings agencies' assessment of their bankruptcy risk is accurate, that the effective tax rate is the lowest average of similar companies, and a whole lot of other things making sure my valuation won’t be the same as yours).

It’d look something like this:

Cash Flows

Share Value

That is if we’re being generous… The current price is still more than twice this very optimistic “intrinsic value”.

Ok, it’s no secret to anyone that GameStop is overpriced. What if they issue shares at this high crazy price and increase their intrinsic valuation?

When the price is higher than value, lenders are more likely to renegotiate debt, plus stock-based compensation becomes a little easier/less expensive. Convertible debt turns into equity at that higher price improving the corporate structure. Issuing shares provides increases value per share, collects cash that can be used to change business model, payout debts, and acquire valuable assets.

AMC, for instance, converted $600 million of debt to equity, making the company far less distressed (btw, one of the biggest winners of this transaction is a hedge fund called Silver Lake – never forget nuance, you guys). Also, AMC happened to have already a prospectus approved for issuance of up to 178 million new shares (#LuckyBastards) so, they also had that option if they want to.

So, why didn’t GameStop do any of that? Well, they need to comply with some SEC regulations and that takes time and approvals and stuff. Additionally, this increased supply would decrease the price of the stock, but it might also kill the momentum driving the price even lower. Third, the increased value per share that you’d get comes from the #suckers that bought the newly issued shares at the increased price transferring that value to the existing shareholders. And lastly, the cash gained from the share issuance might actually get wasted into failed attempts to “save” a non-working business model…

Wait, wait, wait. What’s that about the increased value coming from the new to the old? Imagine that GameStop manages to issue 50 million extra shares at $100, so $5B of increased value meaning that their enterprise value goes from $4B to $9B. That’s amazing! Collectively you now own 65/115 = 56.5% of $9B. This means your collective value increased from $4B to $5.1B, that’s an extra billion in your collective net worth! Buuuut let’s look at the other side of the equation. The new shareholders now own 50/115 = 43.5% of $9B, so $3.9B, except that they paid $100 for those shares, losing transferring $1.1B in the process.

Can this craziness be sustained?

I know that most of you see this and then check the price chart on their screen and think “this time I’ll be able to get in a bit early! From $140 to $300 is doubling my money”, others might say “f*ck no… that sh*t is going to crash so hard again” and even go as far as “imma go buy me some puts”… well, let me stop you right there and say: This is not financial advice, plus I have to disclose that I am exposed to both the upside and the downside of this story (if you wanna know specifically how; leave a comment and I’ll tell ya).

The first question we have to ask is:

Is this different from last time?

I think it is, but it also has the same sort of smell.

Last time it was a combination of squeezes. This time I think it’s the shorts covering along with new hype-based buying and options craziness. What makes me say that? Most of the price increase happened after hours and near the end of the trading day, coincidentally those are times that are outside of the typical trading behavior and access of retail investors but #CorrelationDoesNotMeanCausation. Does this mean that this movement won’t trigger subsequent squeezes? Not at all. Short interest recently went from 50% to about 30% (that's why I believe some of the price movement might be due to some shorts covering), but 30% is still unusually high and possible to trigger a mini short squeeze. What about a Gamma Squeeze? To some extent, it might already have. There was a lot of new interest in OTM call options centered around the $60s (then, later, at about $125) which might have been to blame, but we'll get to that.

Before we get into what happened this time, let’s recap what happened last time:

1.    Short interest was crazy high – it actually exceeded the available float.

How could this happen? Naked shorts (i.e. shorting without really having a way to access them in case they need them), which most smart institutions don’t do, or buying puts. I HAVE to say that most of these institutions won’t enter into a position without capping their risk. So, either they bought put options or they entered into its short position along with an OTM call option (or both). So, these crazy losses that the internet narrative was disseminating probably didn’t really happen.

2.    OTM calls were also crazy high – both from r/WSB users and institutions hedging their short position.

For better or worse, new retail investors know nothing more than the single call/put option buying and are very risk-loving YOLOers. This means that OTM call options, due to their convexity, are their favorite tool (they have the potential to go up really fast with limited downside). So, they buy and buy and buy. On the other hand, Market Makers have to hedge their position, mostly through the underlying for stocks like this one which is almost completely uncorrelated and has a low float. This started moving the price upwards.

3.    Some new shorts entered the market which increased borrowing costs and drove more people that wanted exposure to the downside into puts.

Shorting is never free; you have to pay a fee to borrow the stock and most brokers ask for collateral. As the availability of stocks to borrow starts to decline, the price charged for those shares starts to increase. Plus you need a margin account to do it, so most people just buy puts.

4.    Market Makers needed to hedge these crazy positions – they are the ones that sell these options to the investors (both calls AND puts).

Unlike you, the r/WSB, and Hedge Funds, Market Makers benefit from a working market. They don’t want to take directional risk, so they need to hedge any position they enter to capture the sweet bid-ask spread coming from your orders. They have very limited risk because they’re engaged in the payment-for-order-flow, meaning that they can see and predict the orders coming in real-time and adjust the pricing of their options (you might know this as Implied Volatility). Because of this limited risk, they are allowed to short naked (maybe that’s why the short interest was that high).

• If you buy an OTM call, a MM has to sell it to you so, they have to buy some amount of the underlying determined by the delta of the option contract.
• If you buy an OTM put, a MM has to sell it to you so, they have to short some amount of the underlying determined by the delta of the option contract.

5.    We entered into a double feedback loop.

The price goes up. The delta of the OTM calls goes up forcing the MMs to buy more shares to go delta-neutral again. They also have to unwind their OTM put hedges by buying shares to close their short positions (if the price went down, they would have had to short more shares). This results in ever higher prices which restart the whole cycle. NOTE: the same can happen on the downside! So, be careful when trying to play these things.

NOTE Part 2: if you want more info about gamma squeezes and shorting, just to understand the mechanics, go to the end of the article and check out the explainer section.

So, what about this time?

It’s too recent to say, but it definitely is not the same as last time. There is no exaggeratedly large short interest on the stock, nor a huge involvement of the retail crowd, nor a narrative to increase the hype.

Let's check some possible culprits one by one.

• Short squeeze: Why would people do that? If they shorted it before the last squeeze, I’m sorry for them but they’re probably out of the position by now. If they shorted it after the last squeeze, they probably already made their gains and are fine (or punching a wall if their puts expired tomorrow).
• Fundamentals: HAHAHAHAHAHAHA. Yes, yes, I know they changed the CFO and all, but… HAHAHAHAHAH! (Btw, in regular time, an executive shuffle might stabilize a price movement or maybe increase volatility but leave the stock at a trading range. I think that more than doubling the price of the stock in a few hours is not a typical reaction to that type of thing).
• Blind Faith: Basically the whole “u/DFV just bought more! It means we should buy more” oooor just search for “ice cream cone tweet”, and you won't be disappointed #RyanCohenIsTheSecondComing.
• Gamma Squeeze: Probably… There were a lot of deep OTM calls being bought with expiration 26/02/2020, but most Market Makers would hedge that by MINIMAL positions to account for the tiny probability events. But, sure, as the price increased, they HAD to hedge. There were also a lot of ITM puts with the same expiration which would mean that MMs would have to unwind their hedges if the price increased. These two things probably exacerbated the rally but were not the spark.

So, in conclusion?

It's not entirely clear as of now, but we'll explore it together in my next article. We'll also answer: What’s next with GameStop? How can I find other opportunities like this? How should I trade another situation like this?

For now, all I can say is be careful! There might be a lot of people selling you services and “inside knowledge” that they know how to find the next $GME. They’ll say that you have to check the float, the short interest, the OTM calls, and that sort of thing... They will promise you the recipe for unlimited #Gainz but only if you pay them X amount of dollars which is considerably less than "unlimited" (weird, right?) But don’t be fooled. These events are not that hard to spot IN HINDSIGHT, but they are very hard to time in reality.

Stay tuned, and remember: “Life can only be understood backwards, but it must be lived forwards” - S?ren Kierkegaard.

Explainer time!

Borrowing costs, shorting, and margin calls

The issue with short selling is that almost all brokers expect collateral because they are lending you something and they want to assure that you will pay them back at least something. This requires a margin account btw, so a lot of people can’t.

WARNING: Very simplified example ahead!

So, let’s take the example of a stock worth $50 and you want to short 100 shares. If you sell those 100 shares for $50, you’d get back $5000. Wow! Immediate money! Well, no. You’d have to pitch in, you’d have to put this collateral which for your broker is 50% of what he lent you (initial margin). It would mean that you’d need to put 50% of the proceeds of the sale into the account as collateral in case something bad happens you can cover half immediately. This means that there will be $5000 + $2500 = $7500 in that account MINUS the debt for the 100 shares I borrowed from the broker which would change in price all the time. Let me rephrase that… the second you started that account you “own” $5000 from the sale of the stock + $2500 from what you had to pitch in (both of which would remain unchanged) MINUS $5000 from the market value of the stock you owe to your broker. All in all, you would have $2500 in there to cover half of the $5000 you borrowed in shares. Yes, a bit redundant but I wanted to drive the idea forward.

Now, if one second after you sold that stock, the price drops to $44.5, the new value of what you “own” would be the $7500 that remains unchanged MINUS $4450 (the new market value of the borrowed shares) virtually increasing your portfolio by $550. This also means that you’d be able to cover $3050 out of the $4450 owed making your collateral now 69% #Nice #TheThingsWeDoForAJoke. Of course, the stock could go up, so let’s now say that the stock increases to $75. You would have $7500 MINUS $7500, so zero! Now all the collateral you pitched in is gone and all you have to lose now is in the form of debt which is not so easily collected… So that’s why brokers include minimum margins to force you to put up more collateral if the price moves against you. Let’s say that if your collateral covers only 20% of the value of the borrowed shares, your broker would require you to pitch in enough cash to get it back up to 50% (this is called a margin call). Well, how would that look like? Ok, let’s say that the stock rises to $63 It would mean that you’d have $7500 MINUS $6300 = $1200 and $1200/$6300 = 19% coverage. If this happens, your broker would call you up to pitch in $1950 additional in collateral to keep the position open or they would close the position. If they close the position, it means that you’d have to buy back the 100 shares at $63 to give them back to your broker and book in the loss… But, from $50 to $63 is about a 25% price increase which for some stocks is nearly impossible, except if they have reduced floats and a bunch of coordinated people buying at the same time.

This is without factoring in the borrowing cost which would have to be deducted from your profits. So, if we have a stock with 50% borrowing costs, it means that the stock would have to go decrease by 50% before the end of the year just to break even (or about 4% before the end of the month). So typically, short positions are time-sensitive.

Gamma Squeezes, Market Makers, and YOLOing

Well, let’s try for this one… I'm assuming you read the last article (or know basic options concepts).

WARNING: An even more simplified example ahead.

If the stock price is very volatile it means that the price could change and move your OTM option into the money and earn you a profit. So, if your option expires tomorrow, you only have one day to make it into the money. But if you have one month, you could still make it into the money with the same strike prices. This means that the option expiring tomorrow is way, way cheaper. Let’s make it more visual. Yesterday, a lot of crazy people bought GME FEB 26 ’21 $800 Calls. The price of this option is partly defined by demand and supply and partly defined by a mathematical function that takes into account many variables (some of which influence demand and supply and are influenced by demand and supply - we’ll get into this in part 3). So what? The thing is that these super OTM calls near expiration are the tools of preference for YOLOers (i.e. people who play options like a lottery) because they are cheap, have limited loss potential, have super high payouts when right, and you get to scratch them with a coin. Oh no, this last part is only for Lottery Tickets. But what they do have in common is that they are typically a losing strategy.

When people buy a call, someone has to write the contract and sell it to you. This “someone” is not another person, per se, but typically a Market Maker (i.e. large institutions who offer to be on the other side of most trades in order to guarantee a transaction and/or liquidity earning the sweet bid/ask spread). But, if you’re the Market Maker, you’d want to be careful not to be on the other end of that obligation if the price of the stock skyrockets. So, typically, you’d buy a specific quantity of stock determined by the delta to “hedge” your position against the call and stay delta neutral (I know sometimes they hedge in other ways, but in GME it was probably this way).

Delta? Say that you bought a call. You’d better be mindful of the probability that your call stays in the money after the date. This is approximately (but not really) given by something called “delta”. If you buy an option with 0.2 delta, it means that if the stock price changes by $1, the price of your option would change by $0.2 (more or less, $1 times the 20% probability of it expiring ITM). Market Makers want to be delta neutral, meaning that no matter what happens to the price of the underlying, their position doesn't change (remember that they make their money through bid/ask spreads, not by “betting” on what the market is going to do next. What about Gamma? Well, Gamma is just the rate of change of delta depending on some variables like the change of the price of the underlying or getting near the expiration date. For example, the closer you are to expiration, the more likely that any change in price would drastically change the value of the option because it would significantly change the probability of it being ITM at expiration. If your option has a farther away expiration date, then the gamma would be low because the option price probably won’t change that much with a given stock price change because it still has the time to “catch up”. For example, if GME were to trade around $100 on Friday, the probability of it reaching above $800 by the end of the day is tiny, meaning that the change from $100 to $101 is not going to affect the price of the $800 call. However, if GME was to skyrocket and reach $750, now any change in price (even a $1 change from $750 to $751) would significantly change the price of the $800 contract. Why? Well, because it could very easily end up ITM. And the closer the end-of-day gets, the more volatile the price swings because if the stock stays near $750, then exercising the contract wouldn't be worth it. On the other hand, if the contract didn't expire today but a year from now, any price change today won't really affect the price of the contract because the stock has plenty of time to climb even higher. And if the price stays near $750 at the end of trading on Friday, you wouldn't care because you still had one year to wait for GME to climb above your strike price.

Market Makers need to stay delta-neutral, so any change in gamma changes delta, and any change in delta requires the Market Makers to either hedge or unwind their hedges to stay neutral to the price movement of the underlying. In the case of GME, this probably means buying or shorting the stock.