The GameStop short squeeze will likely be studied by market historians for years, if not decades, to come. Rarely have we seen such volatile moves in a single stock outside of the world of penny stocks. Rarely have new technology and current events combined so dramatically to spark such unprecedented market moves.
To briefly recap, savvy operators on subreddit WallStreetBets smelled hedge fund blood in a massive short float of one of their sentimental favorite meme-stocks GameStop. Adding fuel to the fire was the “us vs. them” mentality so prevalent on social media today.
The end result, between January 13 and February 4, a share of GameStop rallied from $20 to a peak of $483 and back down to the latest close of $53. On January 27th, a new single-day record in options trading was set with 18.5 million contracts traded across CBOE Global Markets’ four options exchanges with GameStop leading the pack representing 26 percent of all options premium traded.
Before unpacking the unique attributes of this particular short squeeze, let’s review the basics.
Some big hedge funds were betting against the survival of GameStop (and likely aiding its demise through media PR). GameStop was painted as the next BlockBuster story – doomed to be buried by tech-savvy competitors as BlockBuster was by Netflix.
The hedge funds borrowed stock from other firms that held the shares of GameStop. They then sold those shares (that they didn’t own) on the open market in the hopes that they could buy the shares back later at a lower price and then return the shares to their rightful owner while pocketing the difference between the price they receive for selling the shares and the (hopefully) lower price at which they bought the shares back.
The trouble with selling shares short, however, is what happens if and when the price of the shares start to rise. The losses potentially suffered by short-sellers are limitless. The price can keep going up and up. To stop their losses, short-sellers have to actually buy the stock back before they can return the shares that they borrowed and sold short. This makes the price go higher.
Starting to get the picture? Wait, there’s more.
Now if you want to really squeeze the shorts (and you have the liquidity to do so), you start buying call options. When you buy a call option, someone is selling you that option and it means that the seller may have to one day deliver you 100 shares of GameStop if the price of the stock eventually rises above your option strike price. In order for the call option seller to protect against this delivery risk, especially if the price keeps rising, option writers need to now buy shares to stop the bleeding. Welcome to the gamma squeeze.
Now that you’ve got the short-squeeze basics, let’s discuss what was unique about this particular short squeeze. It was essentially a social-media crowd-sourced short-squeeze fueled by savvy retail traders and millions of new market participants who were looking for some entertainment, a quick buck, and the opportunity to stick it to the man.
While there is no doubt that the early GameStop activists on r/WallStreetBets were ahead of the curve and knew what they were doing, there is also no doubt that the late-comers buying shares of GameStop at hundreds of dollars a share or, even worse, call options, knew what they were doing.
The question I’m left asking myself is who benefitted the most from this “meme-stock” feeding frenzy. I’m afraid that what I predicted ahead of time, did indeed come true – it wasn’t the retail trader.
We live in a world today that is dominated by technology and digital media. The owners of the big technology and media platforms benefit the most from pure engagement and clicks at almost any cost. That is as true today in financial markets as it is on Facebook, Google, and Twitter.
The data isn’t all in yet, but my suspicion is that the biggest winner in this whole episode is going to be stock trading app Robinhood itself, along with its market-making partners like Citadel Securities. You see, Robinhood has negotiated deals with market-making firms like Citadel where Robinhood earns a percentage of the spread on the trades from their users that they send to the market makers. In 2020, for example, it appears that this amounted to somewhere close to $700 million in revenue earned by Robinhood from market makers. Who knows how much money it also earned for the market makers themselves.
Robinhood makes the most money when its users buy and sell as much as possible and do so in the most illiquid securities possible. I for one, don’t believe that to be a good formula for truly democratising investing.
Dr. Richard Smith – Berkeley Mathematician and PhD in System Science – is a fintech entrepreneur and the CEO of The Foundation of the Study of Cycles.
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