The slightly drunk team talks about the soon-to-be-motion picture topic, GameStop. Find out who is a true believer in the movement, who is doubtful of the meme stock’s future, and what the fuck is going on with this mall retailer stock.
How to understand what’s going on…
Buying A Stock
I think the price of Stock X is going to go UP.
I buy Stock X for $10. The price goes up to $12. I sell the stock and keep the $2 profit.
Shorting A Stock
I think the price of Stock X is going to go DOWN.
I find someone who already owns Stock X and I ask to borrow it temporarily. I sell the borrowed stock to someone else for $10. The price drops to $8. I re-purchase the stock and return it to the original owner.
When I sold the borrowed stock, I received $10. It only cost me $8 to get it back so I made $2 profit.
How Much Money Can I Lose When Buying or Shorting Stocks?
If I BUY Stock X for $10, the most I can lose is $10… if the stock drops all the way to $0.
If I SHORT Stock X at $10 hoping it will drop in price, but the price goes up instead… then I can lose an INFINITE amount of money based on just how high the price can go. For example:
I sold the borrowed stock at $10.
If the price jumps up to $12 and I have to buy the stock to return it to its owner, I’ve lost $2.
If the price jumps up to $1000 and I have to buy the stock to return it to its owner, I’ve lost $990.
Theoretically, there is no limit on how high a stock price can go. So there is also no limit on the amount of money I can lose on a Short if the price continues to rise.
Short Squeeze
Now we’re getting into the fun stuff!
Let’s say that a lot of investors think the price of Stock X will go down, so they all Short the stock (sell borrowed stocks at what they think is a high price).
If the price of Stock X shoots up, some of those investors will jump into the market to re-purchase the borrowed stocks in order to cut their losses. This makes demand for Stock X go up and also causes the price of Stock X to shoot up even higher.
As the price rises higher, more and more Short investors will hit the point where they need to cut their losses. So they buy the borrowed stocks back and drive the price up in a beautiful feedback loop.
Short Squeezes are most likely to happen on stocks for a particular company that is heavily shorted because, if the price goes up, a lot of short investors will feel that pressure and contribute to the rising price feedback loop.
Call Option
At the most basic level, when you buy a Call Option, you are paying a small amount of money upfront for the option to buy Stock X at a certain price in the future.
Today Stock X is $10. If I think Stock X is going to increase to $15 over the next month, I could buy a Call Option that will give me the option to buy the stock anytime in the next month for the price I pick in the call option, let’s say $11.
I think Stock X is going to increase to $15 over the next month.
I buy a Call Option that gives me the option to buy Stock X for $11 at any time during the next month. I pay $0.50 for the Call Option and that money is gone whether or not I decide to purchase Stock X during the next month.
Three weeks later, Stock X shoots up to $15. I exercise my Call Option and buy Stock X for $11. I can then immediately sell my shiny new stock at the market price of $15. I make a profit of $4 (minus the $0.50 cost of the original Call Option).
So, I can pay a small amount of money upfront in order to turn back the clock once I already know the stock price is profitable.
If the price of Stock X went down instead, I let the Call Option expire and it only cost me the original $0.50.
Gamma Trap
Feedback Loop number 2!
Whoever sold me the Call Option above has to be able to deliver Stock X if the price goes up and I decide to buy it using my Call Option. BUT they might not actually own Stock X when they sell me the Call Option.
As the price starts going up, they realize that I’m probably going to use my Call Option so they go out and buy Stock X – to ensure they can deliver on the Call Option AND to make sure they don’t lose a lot of money if the price they have to buy Stock X at is higher than my Call Option price.
If a lot of investors have purchased Call Options and the price shoots up, then everyone who sold Call Options rushes to buy enough stocks to deliver on their promise. This drives the price up even further, which may trigger more Call Options that were tied to even higher prices. And the rising feedback loop continues.
Short Squeeze + Gamma Trap
Things are really heating up. This combination can send Stock X’s price through the roof.
Most investors think the price of Stock X is going to go DOWN, so they buy lots of Shorts.
A renegade group of investors notice how heavily shorted Stock X is. They think the price of Stock X is actually going to go UP, so they start buying Stock X like crazy.
The Short investors get squeezed by the rising prices and have to jump in to re-purchase their borrowed stocks.
The renegade investors anticipate the price increase from the Short Squeeze so they buy Call Options that will let them buy Stock X once the price has gone up.
The Short Squeeze drives up the price, which triggers the Call Options, which triggers the Gamma Trap and the price is forced higher and higher.
How Much Of An Impact Has This Had On Hedge Funds?
It’s fun to “stick it to the Man” but have we really managed to do that? We’ll let you decide.
We won’t know the true numbers for awhile, but here are some interesting stats.
- 2019 Total Assets Under Management globally by hedge funds: $3.1T
- Estimated losses from Gamestop shorts: $19B
Meaning that the hedge fund industry is looking at barely 0.6% losses from Gamestop AND that’s if they don’t actually end up making that back plus a whole lot more from the much higher short positions they were able to claim when the price skyrocketed.
Here’s a list of the 20 largest hedge funds and their individual $ Assets Under Management as of Q2 2020.
Melvin Capital is the hedge fund in all the media headlines that appears to have experienced the largest losses from the Gamestop short squeeze. When Melvin Capital was at $12.5B AUM, before Gamestop losses:
- Pimco’s hedge fund, number 20 on the list above, was still 1.5x the size of Melvin Capital.
- Bridgewater’s hedge fund was 8x the size of Melvin Capital.
The wikipedia list above only counts AUM (assests under management) that are specifically in hedge fund products. Most of the major investment firms also offer other investment products so in reality their total AUM are much much higher. Here’s a list of the Top 100 Hedge Funds as of Q3 2020 by total AUM including but not limited to their hedge fund products.
Melvin Capital doesn’t make the Top 100, even prior to their Gamestop losses.
Compared to retail investors, Melvin Capital is “the Man” but, compared to the hedge fund industry, Melvin Capital might just be “the little guy.”
