Last week was a historic moment in the stock market and the repercussions are still being felt today. For those that haven’t been aware, the beleaguered retailer, GameStop (ticker GME), went from a share value of $76.79 on 1/21/2021 to a high of $347.51 on 1/27/2021 and it currently trades at $119.51 as I write this.
Source: Yahoo! Finance 2/2/2021
So what is going on?! The details are immense and require knowledge of “shorting” a stock and understanding how ‘call options’ work. Therefore, before I explain what happened, I need to provide education on those two things.
“Shorting” a stock means that you are betting it will go down. Simplistically, you place a trade that effectively borrows the stock from someone’s account who owns it. If the stock goes down, you buy it at the current price and the stock gets returned to the account it was borrowed from. Example: You short a stock at $50 per share. The stock price falls to $40 and you close your short. You keep a $10 profit per share minus trading expenses and interest charges. If you are wrong and the stock goes up, you lose money until you close the short. If the stock goes high enough, losses pile up and investors rapidly buy to get out of the short, which drives up the price. This is called a ‘short squeeze’.
Options on a stock are a contract for 100 shares that gives you right to purchase (call option) or sell (put option) a stock at specified price until a specified point in the future. They are typically used for managing risk, but can be used to make leveraged bets. The contracts trade based on supply and demand pricing. The more demand, the higher the cost. Example: You think a stock is going to rise in six months. Rather than buying the stock, you buy a call option, which gives you the right to purchase 100 shares of the stock anytime within the next six months at a specified price. Hypothetically, let’s say you have $5,000 to invest and the stock currently costs $25 a share. You could buy 200 shares or you could hypothetically buy 1,000 shares worth of option contracts for $5,000. The risk is if the stock doesn’t rise, then the contract expires worthless and you lose 100% of your investment! However, if it does rise, now you have gains on 1,000 shares of stock versus 200 shares, so you have magnified your gains immensely.
When it comes to GameStop, it was heavily shorted as it was believed the company was in decline. The shorts were believed to be mainly big Wall Street companies and traders that stood to profit from the decline and GameStop was the most shorted stock in the entire stock market before this move happened. Enter the retail investor and the Reddit group r/wallstreetbets.
A small group of retail investors were sharing information and trades on a Reddit group called “r/wallstreetbets” and they took an interest in GameStop last year. An investor in the group decided to put all his money into GME stock and purchase April 2021 call options in June 2019. The trader called it a “YOLO” trade, which is short for, “You Only Live Once” trade. When GameStop selected a new CEO and there was talk of moving to a digital platform, the stock began to rise. The trader was recently interviewed by the Wall Street journal and was revealed to be Keith Gill. A 34 year old doing trading in his basement and who was suddenly sitting on over a $30mm gain since he started buying. Keith continuously posted his gains to the Reddit group, which attracted more interest and more people began to buy. I feel the group was energized by the attitude that they were going to stick it to Wall Street as GameStop was heavily shorted and they were going to hurt big hedge funds. Their main target was a firm called Melvin Capital. Melvin was publicly shorting the stock and providing public information about why they felt GME was a $20 stock. This angered the Reddit community and they began buying the stock and call options in earnest. This drove the price up dramatically causing a ‘short squeeze’. In addition, when a call option is bought in GME, there is someone on the other side of that trade that sold the option with the belief that the stock wouldn’t rise. As GME began to rise, they got worried that they were going to lose a lot of money, so they began to buy the stock to limit their losses. The buying of the stock en masse then propels the stock up even higher! Hence, why GME shot up to over $400 a share at one point during a trading day!
I have been reading the Reddit group posts and they have their own lingo and call each other ‘fellow retards’ as a badge of honor. While being humorous, they have some serious bets going on and the group expanded to over 7,000,000 members from just a few hundred thousand in the course of the month. They have touted several stocks to buy that are heavily shorted in hopes to make big money. I would have to say the #1 sentiment is to hold GME and hurt the hedge funds. However, Wall Street is smart and saw the trends and trading volume was way too high for just a group of small retail traders. It is widely believed that Wall Street highly benefitted from GME trading and there was manipulation in the stock both up and down. A popular trading app, Robinhood, suspended buying in GME and then limited purchases. Robinhood has people on their board of directors that have a stake in the hedge funds being hurt by the short squeeze. This is still being investigated. However, it is important to note that brokerage firms are subject to financial requirements such as specific SEC net capital obligations and clearinghouse deposits in order to operate. Drastic changes in the trading of volatile & speculative stocks or options can increase the amount of capital needed. This additional requirement may cause a brokerage firm to temporarily suspend trading in these investments until the capital requirement met.
The latest news I’ve read is reporting that the Reddit users are targeting a silver index fund (ticker SLV). However, I have been reading the Reddit boards and they are not touting SLV at all. In fact, they are saying not to buy it and it is fake news. But you know who does own it? Citadel has a huge position in SLV, which was one of the firms that had to give a large cash infusion to Melvin capital for their trading losses in GME. I find it all highly suspicious.
Regardless of all this, the movement in GME is truly market manipulation. A stock should be valued according to the expectation of future cash flows. GME stock was valued under $1 billion before this happened and then turned into a $20 billion dollar company within a week. That was not realistic or sustainable. And the call for fellow Reddit users to not sell GME is not going to keep the value up. There has to be more buyers then sellers. My guess is this ends badly for the retail investors. What could happen is people start to sell and take profits, which begins to drive the stock down. Then people see that and start to think, “Hmm. I should take my gains too.” Then the stock goes down further. Then computer trading algorithms from Wall Street firms catch on and sell and drive it down further. I think investors who shorted at the higher levels cover and many buy on the dip thinking there will be a recovery causing an increase. Eventually, there will be a huge high volume panic sell and the stock will return to a more normal level.
The SEC is looking into what happened to see if this Reddit group committed market manipulation (I don’t believe they did) and why trading was suspended not only on Robinhood, but several brokerage firms. This will be talked about for months to come and will probably be taught in college finance classes in the future. Truly a historic event!
This information is for general purposes and is not intended to provide specific investment advice or recommendations. It is based upon sources believed to be accurate but cannot be guaranteed.
Investing and investment strategies involve risk including the potential loss of principal. Speculative investments such as short-sales and options contain additional risks such as increased volatility and margin requirements. Past performance is not an indication of future results.
The opinions expressed are those of the author and not of Geneos Wealth Management, Inc.Google+