There are a few GameStop stories: a story about hedge funds fleeing before a subreddit on a warpath; a story about how commission-free trading on apps like Robinhood is transforming retail investing; a story about a guy who turned $50,000 into $13.9 million (and counting) and then dunked a chicken tender in champagne.
If you’ve got no idea what I am talking about – read this (and get out [on Twitter] more).
A stock that was trading at $4 last August is now trading at ~$350. The company sells video games in malls.
No matter how this story is told, it involves a cacophony of jargon: puts, shorts, longs, calls, squeezes, brokers, and margin calls. If you are like me, you have followed the story with a tab open to Investopedia, double, then triple checking what a ‘bear put spread‘ is.
One of the fun things about this blog is I get to spend hours learning complicated things that pique my interest, and then explain it to people. What follows is a simplified overview of the financial dynamics behind this vertiginous price rise.
- The shorts. People who believe the price of an asset will fall in the future (Hedge funds)
- The longs. People who believe the price of an asset will rise in the future (Reddit)
- The brokers in between them. People who make money off them being wrong
Now, it is one thing to believe in the future price of a stock, it is another to put your money where your mouth is. How do our shorts and longs actually make money?
- Buy or sell the stock now.
- Buy the right to buy or sell the stock later. This is called options trading, and we are going to come back to it
Stock trading is easy for a long. You buy the stock, check your portfolio every time you go to the toilet, pray, chicken out at the first sign of trouble, sell, then get called a cuck on Wall St Bets when the stock triples a day later – more on them in a minute.
Things are more difficult for a short, how do you sell what you don’t have? Enter the first part of our story – short selling.
When short sellers get caught out
How does short-selling work?
- You borrow a share of Apple worth $10 from your broker. They charge you a fee and ask for some collateral (collateral could be money or another asset)
- You immediately sell it to someone else for $10
- The price goes to $5
- You buy Apple again at $5, return it to your broker, and walk away with $5 in profit minus the broker’s fee
This is the best case scenario for a short, but a lot can go wrong, as we are about to see:
- You borrow Apple worth $10 from your broker. They charge you a fee and ask for some collateral.
- You immediately sell it to someone else for $10
- The price goes to $20
- Your broker calls you: “hey, that collateral was based on an asset worth $10, its now worth $20. I want some more collateral” (This is called a margin call)
- You tell yourself this is temporary, and that the price is about to fall
- Elon Musk tweets that he loves apples
- The price goes to $40
- Your broker calls you – less friendly – “It’s me again, I want some more collateral” (Remember, collateral = money or another asset)
- Apple goes to $60
- You broker has graduated to angry voice mails. You’ve disconnected your phone (for some reason you still have a land line)
- You decide to exit the short. You buy Apple for $60 and return it to your broker. You’ve lost $50, the fee, and any interest on the collateral.
When a short exits, they need to buy Apple, sending the price still higher, and putting pressure on those who remain. This feedback dynamic means concentrated short-sellers are vulnerable to a sudden surge in price. like if, for example, an internet forum organised thousands of retail investors to buy in unison.
Change Apple to Gamestop and your Twitter feed should make sense to you now.
Hedge funds borrowed GameStop shares (lots of them), and sold them, planning to buy the shares back after a fall in price. Instead, Wall St Bets – a Reddit investing forum – organised retail investors into sending the share price soaring. The hedge funds have had to pay margin calls to their increasingly concerned brokers, or exit with a loss – further driving up the price. Attacking an exposed short position with concentrated buying is not a new strategy, it even has a name, a short squeeze. What is new is to see it organised by retail investors with such relish.
The initial case on Wall St Bets was driven partly by the belief that GameStop was undervalued, partly by squeeze exposed short-sellers – GameStop was one the most shorted stocks in the world. It has now taken on a delirious, intoxicating, and quite likely insane momentum of its own.
When brokers hedge
There is another technical dynamic driving this price increase, and it involves our stressed broker and options trading.
Options let you purchase the right to buy or sell a stock for a specific price (called a strike price) by a certain future date. Think of an option like a bet, or an insurance policy – depending which way you think the price will go.
Take the example of Gamestop shares at $40.
- If I buy a call option on a Gamestop share with a strike price of $50, I am purchasing the right to buy a Gamestop share at $50 by a certain date. This could be very profitable if Gamestop shares rose to $100 before then. I could exercise my option, buy a share for $50, then turn around and sell it for $100 in the market. It’s a bet on the price going up. If it goes the other way, I never exercise my option, and simply lose the price of the option.
The important thing to remember is who is on the other side of the trade. For every Redditor buying a $50 call option because they think Gamestop is going to $100, there is a broker selling it to them, in effect committing to the possibility of selling a $100 share for $50 in the future.
Imagine our stressed broker. She’s recording another angry voice message to her hedge fund manager, but her phone is ringing off the hook (lots of people in this story have landlines). People want call options. She gets concerned: if she sold calls at $50, and the price goes to $1000, she is on the hook for a lot of money. To hedge the risk, the broker decides to buy some Gamestop; better to buy it now than at $1000.
And the price goes up.
The price began rising because a motley crew of investors, organised through Reddit. hatched a bold plan. It has kept rising thanks to feedback dynamics from a short squeeze, broker hedging, and hysterical levels of hype. As I write this the New York Stock Exchange opens in 50 minutes. Who knows what happens then.
I highly recommend reading the articles linked in the first paragraph, or subscribing to Matt Levin’s Money Stuff if you enjoy finance more generally.