The GameStop Situation: Simplified
post by Annapurna (jorge-velez) · 2021-01-29T17:55:04.985Z · LW · GW · 13 commentsContents
An attempt to explain what happened this week in plain english None 13 comments
An attempt to explain what happened this week in plain english
By now, you have probably seen the news about GameStop and its stock. I have found most articles and posts on the subject to have either an intermediate level of investment technicality or are simply too long. I am going to try to simplify the situation as best as possible. I will not define terms like ‘stock’ or ‘brokerage’, as it will increase the length of the post. Google any term you don’t know or message me and I will explain further.
When you trade a stock in the market, you can primarily do four things:
- Buy the stock
- Sell the stock (if you already own it)
- Short sell the stock. This means having the investment firm where you hold your account lend you the stock and you sell it. You eventually will have to buy it back and give back to the investment firm. You make money by selling it high and buying it low later.
- Buy to cover the stock. This is the process of buying back the stock you borrowed and giving it back to the firm that lent it to you.
GameStop (GME) is a company that sells video games and consoles in retail locations across North America. The rise in online shopping and ability to buy games and download them directly on the consoles has been very bad for the company over the last few years. The stock price has slowly gone down from ~$55 in 2013 all the way to ~$2.60 in March 2020. From May to August 2020, the stock price ranged from $4 to $6.
The pandemic disproportionately affected GameStop, since most of its locations were closed during the first lock downs. Several hedge funds, which are investment firms that invest institutional investors money in different types of strategies, decided that the company was going to to bankrupt and decided to short sell the stock.
This is the part where things get a little strange. GameStop has about 65 million shares outstanding of which about 47 million are available to trade at any given time. However at it’s peak about 71 million shares of GameStop were shorted. How is that possible? Let me explain with a little exercise:
- Jorge has an account with XYZ Inc. Jorge decides to short GME stock, so XYZ Inc. lends him 1 share of GME and Jorge sells it to Sally.
- Sally, who also has an account with XYZ Inc., buys the 1 GME share from Jorge.
- Jorge wants to sell short another share of GME . XYZ Inc. lends Jorge Sally’s 1 share. Jorge sells the 1 share to Bob. Jorge is now short 2 shares, even though technically he sold the same share twice.
This is an extreme oversimplification of the process, but I hope you get the idea.
Both the 47 million shares available to trade (known as the float) and the 71 million shares shorted at its peak (known as short interest) is public information. Amateur traders that exchange ideas in a sub-forum of Reddit named r/wallstreetbets came up with the following idea: What if we buy as much GME stock as possible, and not sell it, essentially reducing the float to the point that short sellers have a hard time finding stock to buy to cover?
(NOTE: This wasn’t the only reason amateur traders were buying GME stock. Some thought that the business could be turned around. Others thought that they could make a quick buck. But the reason above is the reason we are in this situation)
It is time to oversimplify another process: collateral.
When you short sell a stock, your potential losses are infinite. Let me explain:
When you short sell a stock, you have to eventually buy it back and give to the firm that lent it to you right? So lets say you sold short 1 stock at $100, but the next day the stock is worth $1,000,000 and the firm is asking for the 1 stock back. What happens then? You have to find $999,900 to buy back the stock. Crazy right?
Investment firms have to protect themselves against this possibility. What typically happens is that as the stock price is rising, the firm is going to ask you for collateral. collateral can be cash or stocks in other companies. For example if you sold short 1 stock at $100, and the next morning the stock is at $150, the firm is going to call you and ask you to deposit $50.
Back to the r/wallstreetbets amateur traders, many jumped on the idea of buying as many shares of GME as possible and not selling, reducing the amount of shares traded at any given time. This demand for GME stock started driving the price up, which meant short sellers started losing money and increasing their collateral. The media picked up the story which created a snowball effect: more people started checking out r/wallstreetbets and jumping in on the trade. Some bought 10 shares, others 10,000. Hedge Funds started jumping on both sides of the trade. Business people and celebrities started commenting on the situation. Government started to get worried. This is unprecedented! A coordinated effort to reduce the float and increase the price so that short sellers have to post collateral and/or struggle to find shares to buy?
Yes. For the first time in financial markets history, we are watching a potential crowd sourced short squeeze.
A short squeeze is when a short seller has to buy back the stock they shorted at any price in order to mitigate their losses. In 2008 there was a very famous short squeeze which made Volkswagen the most valuable company in the world for a brief period of time.
The internet and the media are not focusing enough on the fact that this is a coordinated effort.
This week, hedge funds that shorted GME stock are either being forced to increase their collateral or forced to buy to cover their GME stock. This is information is not public so we don’t know exactly what’s going on, but the volatility of the price is telling us there is something going on behind the scenes.
So what is the end game with GameStop? There are many scenarios, but the end game of the central thesis is when short sellers have bought to cover the GME stock they shorted. How do we know when this happens? When we see the short interest decrease from ~88% to more manageable levels.
This primer is intended to those who know very little about investment finance. I oversimplified the situation but my intention is for this post to be a place to start if you want to know what’s going on regarding GameStop.
This is not investment advice. For informational purposes only. I held no position in GME at the time this was published.
13 comments
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comment by swarriner · 2021-01-29T22:24:59.552Z · LW(p) · GW(p)
I am not a true expert, but there is one major element of this narrative that most coverage leaves out— no matter what happens to the short-sellers, the price of Gamestop and other short squeezed stocks must eventually normalize to a "truer" valuation.
I have seen a truly alarming lack of recognition of this fact, with some people apparently believing the squeezed price is the new normal for GME. Here's why that probably isn't the case:
The value of a stock is tied to two factors. One is (broadly) the cash flows one can expect to receive in the form of dividends and other shareholder benefits, the other is the expectation of the stock's value appreciating. Market manipulation like the current squeeze can cause the price of a stock to inflate based on that second factor. As the archetypal example, we look to the housing crash that caused the '08 recession. Thousands of mortgages were given out because it was thought that home prices would continue to rise indefinitely, meaning the loans were low risk (because even if the home buyer couldn't make their payment, the bank could seize the house and not take a loss). This was fine until it suddenly wasn't anymore; the assets lost perceived value, and the remaining fundamentals, i.e. homeowners' ability to service their debts, was not up to the task of keeping the banks solvent.
For Gamestop, I'm told there is some reason to think their fundamentals are getting better from where they were one year ago, but I have seen no compelling reasons that those fundamentals will deliver the kind of dividends that would traditionally command such share prices.
When the short squeeze passes, some Wall Street firms will have taken a big loss, but many small investors will be left holding a stock that may still nominally bear a $300+ price per share, but will probably not be able to deliver the same cash flows or stability as holding the same amount of a business with stronger fundamentals than GameStop. In the absence of people shorting, you end up deciding whether to keep your money tied up in GME, which will return $X over however long you hold it, or some other stock that could return $2x or $3x. At this point, after the short squeeze is resolved, the price will start to fall again.
The investors who were able to sell the $300 stocks to firms obligated to meet short contracts will realize a big cash gain, but anyone left holding the stock after that are likely to be in a seriously bad way.
This, of course, is not investment advice. If I knew exactly when the people holding GME were going to get nervous and try to liquidate, I could just take out new shorts and get rich ( and if enough people did that maybe WSB would just try to squeeze those shorts again!). What all of this boils down to is that this is not the new normal, it is a speculation bubble, and bubbles pop.
Replies from: Vaniver, Borasko, jorge-velez, Dagon↑ comment by Vaniver · 2021-02-01T17:53:09.641Z · LW(p) · GW(p)
In particular, my understanding is that most people who shorted in the early days are now out (including, for some, giving up on shorting entirely) and have realized billion dollar losses, but short interest remains approximately the same, because new funds have taken their place. It was quite risky to think a stock at $4 would decline to $0, but it's not very risky to think a stock at $350 will decline to $40. It remains to be seen where the price will stabilize (and, perhaps more importantly, when) but I think the main story is going to be "early shorts lost money, late shorts gained money, retail investors mostly lost money).
↑ comment by Borasko · 2021-01-29T23:26:49.533Z · LW(p) · GW(p)
I haven't seen almost any traders going off a "real value" analysis for Game Stop. Almost everybody believes Game Stop has a broken business model with no fundamentals, but are all buying it and taking losses just to screw over hedge funds. This is coordinated short-sited financial shitposting out of spite. There is bound to be many losers, but man is it interesting to watch.
Edit: I would also love to see an analysis at one point of the game theory involved getting so many individual traders to coordinate.
Replies from: kjz↑ comment by kjz · 2021-01-30T01:18:05.878Z · LW(p) · GW(p)
It doesn't feel like game theory to me as much as psychology at this point. During the endgame, I agree game theory will play a huge role in individual investors' decisions to hold or sell. But now, it feels like a clear recognition that they are stronger together as long as they all hold, and what's most interesting to me are the simple slogans and short repeatable talking points they use to do so (as well as the excellent analysis that has gotten them this far).
"WE LIKE THE STOCK"
"IF HE'S STILL IN, I'M STILL IN"
"DIAMOND HANDS"
Why do they work so well? Because you only get five words [LW · GW].
It reminds me of an ancient army charging into battle, singing and chanting to maintain morale as long as possible during the struggle.
(Disclosure: I am long GME).
↑ comment by Annapurna (jorge-velez) · 2021-01-29T23:47:07.811Z · LW(p) · GW(p)
I agree with you, but that goes beyond the scope of my intention when writing this post. This post was meant to be as elementary as possible.
↑ comment by Dagon · 2021-01-30T01:12:24.145Z · LW(p) · GW(p)
There are a lot of paths where the "truer" value is actually quite high. Some amount of buyers will forget about it, and just hold the stock long-term. The company itself could find a way to capitalize (heh) on this, before it drops by too much - buy complementary valuable companies with stock, for instance. Even the press is probably valuable, and gives GameStop a great starting buzz for it's (future) online platform.
I'd bet (at lower odds than are implied by price of put options) it's going back down under $75, but no clue if that's over weeks or months, and that's STILL almost 5X where it started the year.
comment by Rafael Harth (sil-ver) · 2021-01-29T20:24:56.554Z · LW(p) · GW(p)
This post is similar to the one Eliezer Yudkowsky wrote.
comment by DTX · 2021-01-31T00:19:28.189Z · LW(p) · GW(p)
I just can't get over that it's Game Stop. I remember when Blockbuster finally crashed in January 2010, I was convinced Game Stop was next and I shorted them then. Their valuation did decline a tiny bit and I made a small amount of money. 11 years later, I can't believe this company still exists.
Replies from: AllAmericanBreakfast↑ comment by DirectedEvolution (AllAmericanBreakfast) · 2021-01-31T03:16:31.596Z · LW(p) · GW(p)
This is a great anecdote to show why it's not a good idea to try and time the market.
comment by norswap · 2021-02-04T03:31:42.188Z · LW(p) · GW(p)
This explanation misses one major piece of the whole affair: it was not only a short squeeze (mostly, it was at first), but also a gamma squeeze (or gamma trap). It has to do with the hedging of option sales.
Here is a short explanation I wrote for a colleague:
Replies from: jorge-velezgamma trap: most options are sold by market makers (e.g. investment banks), and they hedge the options they sell by purchasing (or selling) stock in order to be "delta neutral"
so if they sell one call at the money (strike price = current price), the delta is 0.5 (if the stock price increases by 1$, the call price will increase by 0.5$), and they will buy 50 shares to hedge (now if the price increases by 1$, they are up 50$ on the stock, down 50$ on the call, and they still profit by pocketing the premium)
as an option gets in the money (strike price < current stock price), its delta increases, meaning the market maker must increase the number of stock it purchases to continue being delta-neutral
here what happened is that redditors purchased a lot of cheap out of the money call options (low delta), and as the stock price rose and rose, these ended up far in the money, meaning the market makers had to purchase 100 stocks for each of these calls, driving the stock price higher, and pushing all calls farther in the moneyah, and gamma = the rate of change of delta depending on the stock price (so in particular here the fact that delta increases when an option gets in the money)
↑ comment by Annapurna (jorge-velez) · 2021-02-04T17:32:43.809Z · LW(p) · GW(p)
Yeah I didn't write about the gamma squeeze because I wanted to keep the length of the post short. But you bring up an excellent point.
comment by Ben Pace (Benito) · 2021-02-20T22:56:18.249Z · LW(p) · GW(p)
This was the best simple explanation I read. Thank you.
comment by zby · 2021-01-31T22:24:42.865Z · LW(p) · GW(p)
It just a flashmob. A flashmob in Macy's was so precovid - now we have flashmobs on capital markets: https://zby.medium.com/gamestop-capitol-hill-riots-flashmobs-everywhere-3c1df6333328
Also GME should just raise capital and sell enough shares to get the price more reasonable. SEC should not just allow that - but encourage them.