What a week! Down with the shorts! David vs Goliath! Occupy Wall Street! Stonks!
The current tagline of r/wallstreetbets is "Like 4Chan found a bloomberg terminal", though for most of Thursday and Friday it actually read "Like 4Chan found a bloomberg terminal illness". Which is both clever and the most accurate description possible.
We imagine a lot of people were exposed for the first time last week to some fairly nuanced and advanced financial concepts that got completely mangled in the media because who has time for nuance these days, right? Well, we do! So let's unpack what's going on a bit.
What is short selling? Literally, short selling means selling shares you don't have. If you think a stock is going to go up, you buy it. You're "long" that stock. If you then think it's going to go down, you sell your long position. What if you think a stock is going to go down but you don't have a long position to sell? You borrow shares from somebody else and sell them, making you "short" that stock. If you are short and think the price of the stock will go up, you then buy back shares to close out your position.
Long positions make money when stock prices go up and lose money when they go down. Short positions do the opposite - they make money when prices go down and lose money when prices go up.
Betting against companies? But that's anti-'Merican!
Nuance time. Generally, short sellers aren't taking companies out of business. Occasionally, yes, that will happen, but not because of short selling per se. The most famous example is probably Enron, where it was a short-seller that first discovered the fraud. (That wasn't just a one-off, there are multiple examples of short-sellers discovering fraud that eventually landed people in jail.) Mostly, short selling is a valuation assessment that says "I think this stock is priced too high and is likely to come back down". You could have a perfectly valid investment thesis that would be short a stock, say, GameStop, at $300 but long that same stock at $20.
Also, note that short selling in no way affects the underlying company. When you buy a stock, you're not giving money to the company. The company doesn't care at all. You're giving money to whichever fellow investor is selling you the stock. Might even be a short seller. Similarly, short selling has no bearing on the underlying company. It's just selling a stock to another investor who wants to buy it. If the short is because of fraud allegations, sure, that could hurt the company, but they will either bear out (Enron), or not (Herbalife - see below).
Short selling is a lot riskier than buying a stock, because you have unlimited risk. Or rather, if the concept of infinity is off-putting to you, you have more risk than solvency. Consider buying $10,000 of stock - 1,000 shares at $10 per share. If the stock goes to zero, you lose $10,000.
Now consider shorting $1,000 shares at $10 per share. If the stock goes to zero, you make $10,000. But what happens if the stock goes up to $20? You got $10,000 from selling the shares, but it will cost you $20,000 to buy the stock back to close out the position, so you're down $10,000. What if the stock keeps going up? At $30 per share, you're down $20,000. At $100 per share, you're down $90,000. At $350 per share, you're down $340,000. See where we're going with this?
This phenomenon can lead to what's called a "short squeeze". If a stock moves against you in a short position, you can lose a lot of money real quick. To avoid this, you need to buy back the stock and close out your position. If you have a lot of people short the stock, and a lot of people who therefore need to buy it back to close the position, that buying pressure drives the stock price up further, which compounds losses and makes more shorts close out positions, which generates more buying pressure, which drives the price up, which makes more shorts close out positions...short squeeze. The price gets exponentially higher absurdly quickly as shorts are forced to cover or risk bankruptcy. The short squeeze stops when the shorts have closed out their position, meaning there's no forced buyer at absurd levels and so the stock fairly quickly falls back to more "reasonable" levels. Short squeezes are short-term phenomena, they don't elevate stocks to permanently higher plateaus.
That's only partly what happened (is happening) with GameStop. At the start of the nonsense, there was something like 139% short interest in the stock. That is, people had sold short over 100% of the total shares of the company. Does that make sense? Yes, it's perfectly fine. Having a short interest over 100% is not at all fraudulent or indicative of nefarious schemings. All it really indicates is the potential for a rather vicious short squeeze.
Now that GameStop has risen from $15 to $335, the short interest has dropped to...110%. A lot of the early shorts got massacred (more on that in a bit), but there's a good number that have probably opened new positions. And frankly, if shorting was something we did, the prospects of shorting GameStop at $300 are mouth-watering.
But a short squeeze is only part of the story. The other part is the gamma squeeze that we wrote about back in October. To recap, this was a strategy seen implemented by SoftBank in the tech runup last year and now broadly adopted across the Robinhood and WSB set. Instead of buying the stock outright, you buy out-of-the-money calls. The dealers who sell you the options then go out and buy the underlying stock to hedge their position. If you do that in large enough size (for example: SoftBank or, also for example: 2 million individuals with stimulus checks), the buying pressure from dealers needing to hedge causes the price of the stock to go up, which makes the value of the call options go up, which makes the dealers need to buy more to hedge, which makes the price of the stock go up...gamma squeeze.
So mechanically, you've just had a combination short squeeze and gamma squeeze in various stocks, of which GameStop has been the most notable.
One last technical point to make before we get into the fun stuff - margin. Think of margin and leverage as the same thing. It's the ability to control more money than you actually have. Your investment account is either a cash account (where you can't do this kind of thing) or a margin account (where you can). The point of margin is to jack up returns.
Say you have $10,000 in a cash account. You make a smart investment, it doubles, and you sell. You now have $20,000. Nice 100% return.
Now imagine that same $10,000 in a margin account. The broker will have some "margin requirement", 50% initially but usually in the ballpark of 25% or so for "maintenance". That means that you only need 50% of the value of the account to be your own money. The other 50% is loaned to you by the broker, who charges you interest on the loaned amount. So with your $10,000, in a margin account, you could buy $20,000 of said smart investment. It doubles to $40,000, you sell, pay back the margin loan of $10,000 and now you have $30,000. Nicer 200% return.
See how that works? Same situation for losses. If your investment turned out to be not so smart, in a cash account your $10,000 is now $5,000 and you're sad. In a margin account, your $20,000 is now $10,000 but you still owe $10,000 to the broker. So your $10,000 is now zero and you are very sad.
But it gets worse. Because you have a net zero balance of your own money in the account, you are below the "maintenance requirement" of 25% margin. So you get a "margin call" - the broker calls you up, says you need to get back up to the 25% margin requirement by depositing $2,500 into your account stat or your position will be forcibly sold.
(Note: if your investment was very bad, look what happens if it loses more than 50%: your cash account is down from $10,000 to $3,000, but your margin account is down from $20,000 to $6,000, so your $10,000 is gone AND you're on the hook for $4,000 you owe to the broker. Yikes.)
Alright, technical stuff over, let's have a little fun. Here's what happened last week:
You know how people obsess over celebrities? Like, big time obsess? Like, we have multiple magazines that basically just talk about what they wear and who they're dating? In finance those celebrities run hedge funds. Exclusive, expensive, and for the most part just using massive amounts of leverage to try and generate returns. If you've heard of a name in investment management, there's a good chance it's a hedge fund manager.
Like with horse racing, pedigree matters with hedge funds. For example, if you were a trader for Julian Robertson at Tiger Management back in the day and then went out and started your own hedge fund, you are known as a "Tiger Cub".
So. GameStop is a retail shop in strip malls that buys and sells used video games. The fundamentals do not look promising. Some hedge funds looked at it and said, yeah, it's probably going the way of Blockbuster Video, so we're going to short it. Some of those hedge funds shorted it with massive leverage.
If you look at a 5-year chart of GameStop, it slid from about $30 down to $3 at the March COVID lows last year, and has been bouncing around in the teens for most of the last 12 months. Then, on January 13, some good news: new board directors were announced, including Chewy.com wunderkind Ryan Cohen. Concurrently, it was reported that e-commerce sales over the holiday season quadrupled and now make up 34% of total sales. Huh. Maybe GameStop isn't destined to go the way of Blockbuster after all. The news sent the stock back up into the $30 range, where it spent the rest of the week. And the week after that, actually.
This is important because the two weeks of support at $30 showed that this move wasn't just a flash-in-the-pan...shorts were probably sitting on losses that weren't going away, and plenty of the reddit crowd were likely sitting on gains of 100-200% (or more, depending on how much leverage they were using) and spreading the word. At some point, this morphed from an investment thesis on fundamentals to an investment war of "the little guy taking down the evil Wall Street hedge funds that are short", and both the short and gamma squeezes exploded. After the sustained move to $30 for a couple weeks, Friday the 22nd saw the price jump to $70 before closing the week around $60
Then things got crazy.
Monday - after closing the previous week at $60, GameStop opened at $90 before quickly spiking to $150, then falling back down to $60, then spending most of the afternoon around $80.
At some point today, one of those hedge funds that was short GameStop with way too much leverage - Melvin Capital - got the aforementioned tap on the shoulder for a margin call. And they didn't have the money. So hedge fund out of business, right? Wrong! Because Melvin Capital got a $2.75 billion dollar bailout from Citadel and Point72 (other hedge funds - more on this in a bit, it gets really juicy).
Tuesday - the stock opened at $90ish, hung there most of the morning, and then spent the afternoon climbing up to $150 in a pretty orderly manner. The squeeze was on!
That's another 100% return on the day for GameStop. It's likely that Melvin Capital had already blown through the $2.75B and was facing another liquidity crunch. In hindsight, they are said to have closed out their position at some point on Tuesday, but given the price action that day, there is a very real possibility that some of the $2.75B had vaporized, leaving Citadel and Point72 in the red.
Wednesday - GameStop opened over $300. It dropped to $240, then spiked to $480, then spent most of the afternoon bouncing around the low-$300s before closing at $350.
This afternoon, the first reports surfaced of brokerages restricting trading in GameStop and other names. TD Ameritrade was reportedly first, followed by Robinhood and then other brokerages. Given that we custody with TD, we got on the phone with the trading desk that second because if we're not okay with government lockdowns we're definitely not okay with brokerage lockdowns.
After a bit of a sassy conversation (on our end), it was all good. What TD had done was raise margin requirements on GameStop. Because of the increase in volatility, they were putting a restriction of 100% margin for selling it short. Basically, every account had to operate like a cash account when it came to GameStop. Which we're fine with. Because it's TD who would be on the hook if a bunch of clients start playing around with it on margin and lose a lot of money they don't have. Anecdotally, we had zero issues all week with opening and closing option positions on GameStop through TD.
Initially, we assumed the same was the case for Robinhood. That most of the people complaining about restrictions had margin accounts and perhaps didn't understand what that meant. But then…
Thursday - GameStop opens at $300, then spikes to $480, at which point Robinhood literally blocked the ability to trade in the stock - no buying allowed, just selling. Of course, the stock immediately dropped to $125 (that's close to a 75% drop) while the internet came alive with allegations of fraud, a few quickly-filed class-action lawsuits against Robinhood, and outrage from everyone - Ja Rule, AOC, and Ben Shapiro were all on the same side of this one. In the afternoon, GameStop lifted the restriction and "allowed" people to buy shares of GameStop...with a 3 share limit. The price shot back up to $300 (that's up 150%), then had a bouncy slide down to close the day at $200.
After hours, it came to light that Robinhood was in trouble. They had to tap their lines of credit and raise a new $1B from existing investors, literally an hour or two after the CEO was on CNBC saying they didn't need to raise money. Why did they need money? That's a grad-level newsletter, but the tl;dr is collateral for all the trades they facilitate.
It's very likely this is the truth. But the optics on it suck. Back to those hedge funds that bailed out the failing Melvin Capital:
The $0.75B came from Point72, run by Steve Cohen, formerly of SAC (SAC is kind of equivalent to Tiger in terms of spawning a hedge fund community). Back in 2013-2014, SAC was charged with securities fraud, pled guilty to insider trading, paid $1.8B in fines, and had to close down. So now Cohen (miraculously not in jail and having served his two-year ban of managing money) is running Point72. One of his former SAC traders? The guy who runs Melvin Capital and got blown up by GameStop.
The other $2B came from Citadel. Anybody know how Robinhood makes money? It's not on trades, because they're commission-free. They make their money by selling client order flow to various high frequency trading desks. Guess who pays Robinhood the most for this order flow? Citadel.
So Robinhood happens to shut down trading (buying, specifically) on its platform at the same time that its largest single revenue stream (Citadel) is on the hook for billions of dollars that are getting vaporized by the very trading that's happening on Robinhood's platform!
Friday - By now there's a full-on, global, anti-hedge fund backlash going on and people are pouring money into GameStop simply because they want to screw the finance-specific version of Davos Man. It opened at $350 and mostly stayed in the $300's all day, closing at $325.
Robinhood put out a blog post right before the market closed stating that there would be position limits going forward in various stocks. 51 stocks, to be exact, ranging from the "usual suspects" of GameStop, AMC, Blackberry, Bed Bath & Beyond, Nokia, etc. through the "they're next" rumors of American Airlines and silver all the way through "boring" Starbucks, GM, and Advanced Micro Devices.
What's the position limit on these 51 stocks? Well, 15 of them have limits of 5 shares. The other 36 have a 1 share limit. Now get this: while you are only allowed to have 1 share of GME at Robinhood, you are allowed to have 5 options contracts on GME. Every options contract is the equivalent of 100 shares. So you get 1 actual share...or basically 500 shares through options, which seems...weird.
Robinhood has effectively stopped functioning as a brokerage platform, which either means Citadel opened a short position in a lot of the names on that restricted list and is looking to make a quick buck and the conspiracy theory has some merit...or Robinhood is desperately trying to deleverage because they are still in a massive liquidity hole and about to go the way of Lehman Brothers. If that's the case, we should know pretty early this week.
Things to pay attention to: will the fight stay in GME or will it expand into other stocks that a lot of hedge funds have short positions in? Will the regulators get involved for market manipulation? And if they do, will it be against Robinhood for manipulating markets down, or will it be against WSB for manipulating markets up?
It has taken almost a year, but the outcry against broken and corrupt institutions that started last year (we'd say in healthcare, state unemployment agencies, and government in general, with the education system being added more recently) has now made its way to the financial markets. And with r/wallstreetbets growing from something like 2 million people to 7 million over the course of last week, there's a good chance more fireworks are in store for February.
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