The GME saga, in brief

If you know what’s going on and want to get straight to weaponized gamma, skip to the bottom.

GameStop (GME)

GameStop is functionally obsolete given that video games are now downloadable as software and don't require physical disks sold at brick-and-mortar shops.

GME trades at ~$5.00 as recently as August 2020. 

The prevailing thesis was the stock was going to zero. A huge short interest exists as a result (reaching levels above 100%).

Andrew Left and Citron Research are short. Publicly.

Michael Burry ("The Big Short") is long. Publicly.

Reddit and the kids (I use that term in awe) at r/wallstreetbets catch wind of the stock. One redditor in particular, whose username cannot be repeated in polite company, makes a case for why GME has some value. The wsb hivemind is convinced and rallies behind the beloved company for a chance to collectively stick it to the man, sending the stock soaring from single digits to double digits to triple. 

A short squeeze ensues as short sellers are forced to cover. 

Who are the short sellers? Institutions. Hedge funds. Colloquially: Wall St. 

It's interesting to note that Robinhood, the app notoriously responsible for bringing an army of retail traders into the market with a gamified UX and no-fee trading (more on that below), doesn't offer short selling*. Robinhooders are long almost by definition. 

So the redditors/Robinhooders found themselves sat opposite Wall St./hedge funds and, for once, whether anyone knew it, they were in the same weight class. 

One hedge fund in particular, Melvin Capital, headed by Gabriel Plotkin, protégé of Steve Cohen, was so exposed it nearly (just yesterday) went under. It was ultimately saved via a $2.75bn investment from Plotkin's former boss, Steve Cohen (Point72), and Citadel (more on that below).

Unfortunately for Melvin, GME has more than tripled again since yesterday's close of $81 to nearly $300. 

Redditors over at r/wsb are determined to take the stock to $1,000 and have a thesis as to why it's doable. 

The short interest continues to grow through the squeeze. That's the opposite of what you would expect to happen. Short squeezes happen when shorters are forced to cover, i.e. reverse their trade by buying – and returning – the shorted – and borrowed – security. This should have the effect of decreasing the short interest. The fact that it continues to grow suggests that hedge funds may be attempting to break the rally by applying selling pressure. Since they don't hold shares, their only means of selling is to continue selling short.

GME's short interest is so large that it's unclear if the available shares on the market are sufficient to cover which means short sellers may eventually have to buy at any price to prevent theoretically infinite exposure. If the rally continues, it'll be purely due to quirky, aberrative, insane market dynamics.

Options

An obvious question is how can retail investors move the market like this, even with the coordinating power and righteous mob energy of the internet? Why is the market so goofy? Why does it feel different this time around? Well in some ways, it is. And the reason for that is options.

In the dot-com bubble, retail speculators were buying actual shares. The amount of buying pressure they could exert on the market was proportional to their risk. Today, now that reddit has popularized options and Robinhood has made them easy to buy, speculators can exert far more buying pressure on the market compared to their risk.

We’ll focus on call options here since stocks always go up. When a call option is purchased, the writer of the option is a dealer-bank. Thanks to the Volcker Rule, banks can't take on any risk in these situations so in order to be neutral on the trade, the dealer-bank must buy shares of the underlying security as a hedge: if the call option is successful, the bank will have to pay out, but the success of the option is based on appreciation of the underlying security which the bank bought as a hedge. So the bank must buy enough of the underlying security to break even in the event that the option is exercised. Since options are inherently levered, the value of the hedging shares the bank must buy far exceed the value of the options purchased.

It’s complicated if you’re not familiar with derivatives but crucial point is that options traders have realized they can, using the leverage of options and the power of coordinated crowds, exert an outsized amount of buying pressure on equities relative to the capital they are willing to risk.

Gamma

Banks calculate how much actual stock they need to buy to hedge their open call option contracts using something called delta. Delta is the measure of the change in the price of an option relative to the price of the underlying stock. The higher the delta, the more shares they need to buy to hedge their position. 

Now the closer the options get to being in-the-money (i.e. the strike price), the higher the delta, which means rising prices force banks to buy more and more shares in order to maintain their hedge. But not only does delta increase as the share price approaches the strike, the speed at which it increases increases. This is gamma.

If delta measures how much the price of an option changes relative to the price of the underlying stock, gamma measures how fast delta changes. What acceleration is to speed, gamma is to delta. 

As traders push prices higher, banks writing the call options are compelled to buy exponentially more of the underlying shares which creates a positive feedback loop of further buying pressure – AKA a gamma squeeze. Savvy investors have caught on to this phenomenon and have begun buying – and encouraging others to buy – large volumes of call options en masse, weaponizing gamma to drive price spikes that look vertical on a price chart.

This will likely end in disaster for most but either way, this may be the craziest market action we ever see.

Folks are mad the wrong people are manipulating the market this time around.

Possible Outcomes

  • 1 – 2 hedge funds collapse

  • Retail gets smoked

  • New SEC regulations

  • Christian Bale reprises his role as Michael Burry in The Big Long

Robinhood & Citadel

The reason Robinhood trades are free is because Robinhood makes money on each trade by selling the trade data to high frequency traders (HFTs) like Citadel. When you make a trade on Robinhood, HFTs know about them nanoseconds after you hit "confirm" and nanoseconds before the trade is actually executed. In those nanoseconds, HFTs can choose to front run your trade by executing the trade before you do. By seeing all of Robinhood's order flow, they can effectively see the future of all transactions on the platform. And apparently they can earn enough doing this to rescue hedge funds like Melvin Capital who have to follow the market in real-time like the rest of us.

* Robinhood does offer put options, however put volume is titanically dwarfed by call volume.