Over the past few months, the largest financial story has been GameStop. In January 2021 the brick-and-mortar retailer GameStop was on the brink of bankruptcy when it was caught up in a trading frenzy. Massive bets (I lack a better word for this level of speculative investing) were placed on the stock. Hedge fund managers bet that the stock value would go down and smaller retail traders bet that the stock would increase in value. Normally retail investors are quickly and easily dispatched in these battles, but the retail traders were effectively organized through the online chat forum WallStreetBets. Although much is unknown about the true winners and losers, one hedge fund involved in this battle, Melvin Capital, lost at least $6.5B. For those of you who had fun doing something other than reading financial news, this post retells the GameStop saga, which highlights the risks of active investment management.<\/em><\/p>\n\n\n\n

The saga began with one investor began to post about the run up in institutional investors began betting against GameStop in mid-2019. The premise was that GameStop, a brick-and-mortar retailer of video game consoles and new and used video games, was in a market increasingly moving online. The consoles are now sold online, and the games downloaded directly from the console maker to the user. The allows manufacturers and developers to cut out the middleman, increase their margins, and eliminate the possible resale, a large part of GameStop\u2019s market. According to GameStop\u2019s 2018 annual report, pre-own sales accounted for 43.4% of sales, and new software sales were 21.5%, meaning 65% of their revenue was at risk from changing market dynamics. GameStop\u2019s response to investor concerns was to change reporting segments in their SEC filings in 2019 and no longer provide this level of detail. We do know that total revenue was down 22% between 2018 and 2019, through the first 9 months of 2020, sales were down 31% from 2019.<\/p>\n\n\n\n

Given these numbers, \u201csmart money\u201d (industry jargon for mutual funds, hedge funds, and other large investors) assumed that GameStop would eventually go bankrupt, and the share price would decrease to zero. The financial transaction used to make these bets was \u201cshorting the stock.\u201d Shorting allows a trader to borrow the stock from stockholders, get cash, and then, when the stock goes down, buy it back at a lower price.<\/p>\n\n\n\n

For example, if I thought Tesla was overpriced, I could borrow a share from someone who owns it. If the market price was $700, I would sell it for $700. Now I have $700 in cash. If the market price falls to $650, I would buy the share of Tesla back for $650 and return the share to the original owner. I have made $50. If the price goes up, though, I lose money and interesting things happen.<\/p>\n\n\n\n

While I didn\u2019t put any money on the line in the first part of that trade\u2014I gained cash of $700\u2014I did take on the liability of buying the share of Tesla back in the future. This liability makes brokerage houses nervous because they are on the hook to return it to the original owner. If the price falls and I start making money, the brokerage is fine because my liability is going down, but when the price of the stock goes up, so does my liability. As the liability increases, it triggers a margin call. A margin call refers to a broker’s demand that an investor deposit additional money or securities into the account to bring it up to the minimum value, known as the maintenance margin. The maintenance margin can vary by the size of the investor as well as the broker\u2019s policies, but it\u2019s important in this story only to realize it exists.<\/p>\n\n\n\n

The Tesla example ignores another fee that the short trader is incurring: the cost to borrow the stock. The cost to borrow is based on an interest rate that is determined based on supply and demand. The more people who want to short a stock, the higher the rate and the more costly for the short trader. (There are other costs such as dividends, but we need to keep the story moving).<\/p>\n\n\n\n

How did the retail investors managed to pressure the larger institutional investors? The first person identified posting information on the GameStop situation was Keith Gill, under the name RoaringKitty on YouTube and DeepF***ingValue on Reddit. By his analysis the shorts on GameStop were too massive, despite the headwinds GameStop was facing. At one point in January 2021, the total shorted shares were 140% of shares outstanding. He reasoned that so much downward pressure was artificial and that the health of the company was not as bad as the stock price indicated. Even better, he had a plan. But before I get to that that, I bet you are wondering how you can have more short interest than shares? Here is an example of how that happens:<\/p>\n\n\n\n

Take a scenario involving four investors. Kat owns shares of GameStop. Kat and her broker have an agreement that allows the broker to lend Kat’s shares to short-sellers. It lends them to Alex, who subsequently sells those borrowed shares short in hopes that GameStop’s share price will fall.<\/p>\n\n\n\n

An investor named Brooke ends up buying those borrowed shares from Alex. However, Brooke has no way of knowing that those shares have been borrowed from Kat. To Brooke, they’re just like any other shares.<\/p>\n\n\n\n

More important, if Brooke has the same kind of agreement, then Brooke’s broker can lend out those shares to yet another investor. Connor, another GameStop bear, can borrow those shares and sell them short.<\/p>\n\n\n\n

Now the same one share has been shorted twice for a 200% short interest, assuming it was the only share of the company.<\/p>\n\n\n\n

RoaringKitty planned to profit by buying and holding GameStop shares. But then Gill did something more interesting. He bought the shares and proposed investors buy out-of-the-money calls. Out-of-the-money call options are options where the strike or exercise price is above the current market price. Out-of-the-money call options are a cheap way to get leveraged exposure (more exposure than your capital would normally allow) to an increase in a stock\u2019s value, especially if they are short-term options. The shorter duration, however, also increases the risk, because if the market price does not go above the strike price on the option, you lose 100% of your premium.  An option is buying a financial contract that gives the buyer the right, but not the obligation, to buy the underlying stock at a certain price if it goes above the strike price.<\/p>\n\n\n\n

RoaringKitty saw that if enough people purchased out-of-the-money call options, the market makers (the people writing these options) would be forced to buy shares of underlying stock to hedge their position in case the options did go into the money. If enough buyers of out-of-the-money calls could be brought in, the market price of the stock would go up and the value of the call options purchased would increase. As the investors of these options made money, the plan was to roll those gains into new out-of-the money calls and continue the cycle.<\/p>\n\n\n\n

RoaringKitty documented this plan in detail on WallStreetBets, along with screenshots of his actual position in GameStop at the end of every month. He did this for over a year, and as he did, he and his investment theory gained a cultlike following. Users began posting stylized photos, memes, and short clips hyping both GameStop stock and RoaringKitty, which generated even more interest in the trade.<\/p>\n\n\n\n

As the stock price increased, short sellers started incurring margin calls, forcing them to either come up with additional capital or close their positions. They forgot the wisdom of John Maynard Keynes who once said, \u201cThe markets can remain irrational longer than you can remain solvent\u201d and the \u201cshorters\u201d increased capital to maintain their positions. Most institutional investors try to hide their losses to not rattle confidence in their other investments, but we do know that Melvin Capital received an equity infusion of $2.75B from two other hedge funds so they could maintain liquidity.<\/p>\n\n\n\n

But $2.75 billion doesn\u2019t go as far as it used to, and Melvin Capital needed to start closing its short positions. (The pressure to close their positions is what is referred to as a \u201cshort squeeze.\u201d) As these short positions are closed, the additional buying creates more demand for the stock and increases the market value, further intensifying the cycle.<\/p>\n\n\n\n

When the value of the stock is on the way up, this cycle is amazing. The problem is this level of financial engineering by both sides decouples the value of the stock from its underlying fundamentals, creating an extremely volatile situation. This can be seen in the wild fluctuations in the price of the stock in the chart below.<\/p>\n\n\n\n

<\/a>