O, K-SHAPED RECOVERY BOOMER
Last year was a good year for hedge funds. Their luxurious sedan chairs, powered by the twin porters of loose monetary policy and fiscal stimulus, sprinted them comfortably up the arm of the K recovery. D1 Capital Partners, a privately owned investment management firm, performed particularly well. They are reported to have enjoyed a 60% gain during the plague year. Pandemic earnings from other outfits, meanwhile, were similarly fruitful. Steven A. Cohen’s Point72 Asset Management earned its founder $1.4 billion. That was enough to cover roughly half of his tab for the New York Mets which he purchased in November. In all, as the coronavirus ripped through poor communities and ravaged economies, long-short strategy hedge funds such as D1 Capital and Point72 reaped double-digit returns. Perched atop the winner’s platform of the K serif the view must have been breathtakingly beautiful.
Then, last week, they got gut punched with the ferocity of a blow delivered by Mike in his prime, suffering massive losses in a week of generational market turmoil.
It wasn’t pretty.
In fact, it was a bloodbath.
D1 Capital posted 20% losses. Steven A. Cohen, in a loss only a New York Met could possibly conjure, witnessed 15% of his firm’s position evaporate like so much run production behind a Jacob deGrom Cy Young Award winning season. Melvin Capital, categorically blitzkrieg bopped by the turmoil, had to seek out a lifeline injection of $2.75 billion in order to stay in business after taking a $4 billion loss. The hurt spread rapidly throughout the industry. By Wednesday the hedge funds were running scared. Billions were lost.
Volatility comes at you fast, bro.
What happened is that the nation’s financial elites, the so-called masters of the universe, got pantsed by a crowd-sourced call option short squeeze Gamma stonk for the ages.
WHAT EXACTLY IS A CROWD-SOURCED CALL OPTION SHORT SQUEEZE GAMMA STONK?
The first thing you need to know is that this all started on Reddit.
Reddit bills itself as the “front page of the internet.” It is populated by largely anonymous users, redditors, who organize themselves into thematically ordered message boards called subreddits. Subreddits are a place for redditors to gather for discussion of topic-specific items and to exchange links on the same. Reddit hosts an impossibly diverse collection of subreddits. If it exists there’s probably a subreddit for it. You can, for instance, join a subreddit dedicated to economics, or the military, or cats. There’s even one for people to read and discuss one chapter of Leo Tolstoy’s War and Peace each day.
The retail investors behind last week’s market pandemonium are part of the WallStreetBets subreddit.
WallStreetBets describes itself as some combination of 4Chan and a Bloomberg terminal. That’s fitting because a simple scroll of the subreddit reveals a healthy mix of internet memes and financial colloquy. Over the course of the last few months conversation on WallStreetBets slowly coalesced around GameStop, a beleaguered video game vendor.
On January 4, 2021 the stock price for GameStop was a paltry $17.25. Many people, many financially sophisticated people as we’ll see later, thought even that was too much to ask for it. When the markets closed this Friday, however, GameStop was priced at $325.00 per share. On a graph that rise in stock price represents a right-angle to nearly Euclidean perfection. This doesn’t happen often. Only a call option short squeeze gamma stonk could produce it. And that’s exactly what WallStreetBets smacked the hedge funds with last week.
This is where things get complicated. To understand what happened in WallStreetBets’ assault on the hedge funds you’ll first need to understand what a short is and then what a call option is.
Let’s start with short selling.
A short is a bet that a security will fall in value. It occurs when Party A borrows a security from Party B and sells it on the open market with the promise to return it to Party B later. Party A hopes the security will decrease in value between the time he sells it on the open market and the time he returns it to Party B.
Let’s look at a concrete example.
Imagine a man named Aristide Saccard. Aristide has been looking at a publicly traded bank, Banque Universelle. Aristide isn’t happy with Banque Universelle’s financial statements. The fundamentals, he thinks, are all off. Aristide believes Banque Universelle’s stock is vastly overpriced at $10 a share. A correction downward, he believes, is in the cards.
So Aristide goes to his brother Eugene who happens to be a broker and borrows 100 shares of Banque Universelle from him. Aristide then sells these 100 shares on the open market for a tidy sum of $1,000. And guess what? Aristide is right. Banque Universelle is overpriced and a few days later its share price drops to $1.
Aristide Saccard, happy bastard, closes out his short position in Banque Universelle by purchasing 100 shares at the current $1 price and returns the shares to his brother Eugene. Aristide has produced a handsome profit of $900 for himself on his short of Banque Universelle.
Good for Aristide!
Bad for Aristide, though, if the price of Banque Universelle increases.
If that happens, Aristide is, to borrow from the technical financial jargon, completely fucked.
Recall that Aristide’s short position in Banque Universelle obliges him to return 100 shares to his brother Eugene’s brokerage. If, say, the price of Banque Universelle’s stock surges to $100 a share Aristide has to pay $10,000 to buy the shares he owes his brother’s brokerage. He’d be out $10,000 rather than up $1,000.
In fact, he’d be out even more than that because of the mechanics involved in opening a short position with a brokerage. As you may have already deduced, the theoretical potential losses in a short position are infinite because there is no ceiling to a stock’s price. Because a stock’s price has no limit brokerages do not open a short position for clients without first opening a margin account for them.
A margin account is an account used by brokerages to lend clients money so that clients can purchase financial instruments. The account is maintained by collateral and a periodic interest rate. This protects the brokerage from a client’s losses.
In our example, Aristide’s margin account is collateralized with Banque Universelle stock and whatever periodic interest rate Eugene’s brokerage requires for the margin account. So long as Aristide’s bet goes well, if the market price of Banque Universelle drops, he has nothing to worry about. But if the stock price rises he is in trouble. Deep trouble.
If the price of Banque Universelle increases too much the losses could breach the account’s maintenance margin. Aristide doesn’t want this to happen. The maintenance margin is the minimum equity a client is required to hold in a margin account. The Financial Industry Regulatory Authority sets this requirement at 25% the value of a margin account’s securities. If the maintenance margin point is breached in a margin account the client gets hit with a margin call. This is doomsday.
A margin call requires the client to deposit more cash into his margin account in order to make up the difference between the security’s price and the maintenance margin. For Aristide, if the price of Banque Universelle gets too high the margin call is similarly expensive. Aristide is then faced with a tough decision.
If he still believes he is right about Banque Universelle, that the stock price will eventually fall, he must inject more cash into his margin account to satisfy its maintenance margin. Keep in mind that he must also continue to pay the periodic interest charge on top of that.
Aristide’s other option is to close out the short. This requires him to purchase the 100 shares of Banque Universelle on the open market at the current price and return the shares to the brokerage.
The effects of a margin call can be devastating to an investor in a short position. Remember this for when we return to the battle between WallStreetBets and the hedge funds.
For now, however, let’s learn a little bit about call options.
The first thing to know about call options is that they are contracts. They are not stocks. The call option contract entitles an investor to the opportunity, though not the obligation, of purchasing an asset, typically shares of stock, at a specified time for a specified price. The specified time is called the expiration date. The specified price is called the strike price. The price of a call option is known as the premium. The investor pays the brokerage the premium in order to enter into this contract.
Investors purchase call option contracts in the hopes that the underlying asset’s value increases. A call option, therefore, is in some respects the opposite of a short.
Let’s return to our friend Aristide Saccard to better understand what a call option is and what it can do for an investor.
Aristide is still interested in Banque Universelle. Only now he believes that its current stock price is undervalued at $10 a share. Aristide is so sure of it, in fact, that he goes to his brother Eugene’s brokerage and executes a call option to purchase a contract for 100 shares of Banque Universelle with a strike price of $15, an expiration date of one month, and for a premium of $5.
At the expiration date Banque Universelle is sitting pretty at $20 a share. Aristide decides to take delivery of his call option. He purchases all 100 shares at the strike price of $15. So far he has spent $1,505 ($1,500 for the 100 shares and $5 for the premium). Now, when Aristide sells those 100 shares on the market at current market prices he will turn a $495 profit. Not bad.
But what happens if Aristide is wrong about the direction of Banque Universelle’s stock price? What if it falls? Is he in as much trouble as he was in his losing short position? Not even close. The maximum Aristide stands to lose on a call option is the premium he paid for it. If the stock price exceeds the strike price at the expiration date he’s out only $5.
That is how a call option operates on the client side. If we’re to fully understand what happened in the markets last week we also must consider the brokerage side of a call option.
A brokerage is a middleman connecting buyers and sellers. Brokerages typically do not sell assets directly to investors. Instead, brokerages rely on market makers to do that. It is market makers who hold and sell the securities investors purchase through brokerages. Brokerages facilitate this exchange between market makers and investors and collect a fee on each transaction they execute.
Market makers are not dummies. They understand that financial markets are volatile and that this volatility puts them at significant risk, particularly when engaged with options trading. To address this concern they have developed something called Delta hedging. Delta hedging is exactly what it sounds like. Delta, as I’m sure you recall from your high school math class, is the Greek letter mathematicians use to denote change. To hedge is to take measures to protect and defend oneself. In finance terms, then, Delta hedging is any action taken to guard against the changes, or volatility, involved in the trading of financial instruments.
In a call option the Delta is the change in the value between the call option contract and the market price of the underlying asset. Market makers hedge call option risk — the potential that the underlying asset will outpace the value of the contract — by purchasing an appropriate amount of stock in the underlying asset.
Finally, a word about Gamma. Gamma is more than just another letter in the Greek alphabet. In finance Gamma is the first derivative of Delta. That is, Gamma is the slope of the Delta at any given point. So the steeper the positive Gamma the larger the Delta.
LOOSE THE GAMMA STONK!
And now we’re ready to learn how it was that a bunch of retail investors on Reddit put the hedge funds on their ass last week.
Savvy readers may have already put the pieces together but for those who have not we start with the fact that hedge funds have been amassing huge short positions in GameStop stock. They’ve been amassing huge short positions in GameStop stock because GameStop is a company in decline. Gamestop’s business fundamentals are simply out of step with projections of where the video game industry is heading. More people are buying games digitally than are buying physical copies and GameStop sells only physical copies. GameStop has simply failed, so far at least, to adapt to this new business environment and has recently been paying the price. The Economist shares the specifics on the trouble GameStop is in: “In the five years to January 31st 2020, its share price fell by 85%, while the S&P 500 index rose by 79%. Its sales were down by 28% over that period and the losses from continuing operations in the two most recent years came to around $1.3bn. The company launched a ‘multi-year transformation initiative’ in May 2019 that involved a switch into e-commerce, but the pandemic added another problem; in the third quarter of 2020 its net sales declined by 30%, year on year.”
That’s why the smart money, up until last week anyway, was on shorting GameStop.
But last week was the week the smart money got dumb and the dumb money got galaxy-brained.
Hedge funds, the so-called smart money, had built up their short positions in GameStop to around 140% of outstanding shares. That was a colossally stupid thing to do and the dumb money over at Reddit on WallStreetBets was about to show them exactly why.
The WallStreetBets redditors, those magnificent Dutch tupiling maniacs, understood they could pump GameStop’s share price up to heavenly levels with a relentless Gamma stonk on the GameStop trade. Note: for WallStreetBets the word stonk is an intentional misspelling of the word stocks. For purposes of this article, however, stonk also assumes its traditional definition as a concentrated artillery bombardment. Because that is precisely what WallSreetBets did. They Gamma stonked so hard, in fact, that by Wednesday GameStop was the most heavily traded stock on Wall Street and by Friday, as we’ve seen, its listed price on the New York Stock Exchange was an unbelievable, and most likely unsustainable, $375 per share.
The Gamma stonkers achieved this feat primarily, but not exclusively, by means of call options trading. Financial Times reports that the call volume of trading activity exceeded one million trades per day last week. That’s wild. It’s also why GameStop’s market capitalization is so high right now.
See, Gamma stonking on a heavily shorted stock’s trade creates a virtuous cycle of benefit for the call option trader and a death spiral for the short seller.
Here is why:
Stock valuation is subjective. A stock is worth as much as people are willing to pay for it. When more people want to buy a stock its share price rises because there are only so many shares to go around. So a massive increase in demand, like what we saw last week, increases its value. An increase in call option trading really increases its value because, remember, the market maker Delta hedges in order to remain directionally neutral. With every call option contract, and there were literally millions of them last week, the market makers Delta hedged by buying more shares of the underlying asset. The bigger the Delta, the steeper the Gamma, and the more shares the market makers had to purchase in order to keep their position even. These market dynamics strapped GameStop’s share price onto a rocket and launched it to the moon.
While the Gamma stonkers celebrated the rise in share price, the hedge funds who had shorted it were not so happy. GameStop’s 1,600 %+ year-to-date increase in price forced many of them into closing out their short positions. To do that, of course, they had to go to the open market and purchase all the shares they had shorted at the new ballooning market prices and from the very people, WallStreetBets, who were presently murdering them. It was beautiful. Especially because the extra demand caused GameStop’s price to continue its improbable ascent even higher.
FROM VALUE TO RADICAL
It’s easy to see why WallStreetBets pounced on this historic opportunity. Everybody likes making money. The GameStop rally didn’t start as a Gamma stonking operation though. It began with good, old-fashioned value investing. The kind that would make Warren Buffet proud.
Value investing is an idea popularized by Benjamin Graham and David Dodd in their classic text, Security Analysis. Security Analysis argues that there are moments when asset prices are mispriced in financial markets. That is, there is a difference between an asset’s intrinsic value and its market pricing. This difference can be exploited by the discerning investor who can buy low before the stock goes high. Discerning investors identify these mispriced moments through deep analysis of financial statements.
This is the kind of analysis WallStreetBets redditor DeepFuckingValue, known as Roaring Kitty on You Tube, was doing in this video from July of 2020 when he argued that GameStop, contrary to the predictions of the hedge funds, was actually a value play. In his opinion, GameStop was undervalued as an asset and so, as a value investor, he bought in with the expectation that the share price would rise. As we know, he was right, and on the GameStop trade alone DeepFuckingValue is now a multimillionaire.
The GameStop rally may have emerged from within the placid pages of Security Analysis, but by the time it became clear that the market moves were guillotining hedge fund profits the rhetoric surrounding each trade of the stock more resembled Robespierre’s Report on the Principles of Public Morality.
Indeed, the fiscal Jacobins at WallStreetBets made it clear that the purpose of their portfolios now was not to draw on the future earnings of a diversified set of healthy public companies but, rather, to gleefully impose maximum losses on the nation’s financial elite. “Watching entitled institutional shorts whine on TV and OP EDs,” wrote one of them to Bloomberg columnist John Authers, “that millennials equipped with margin accounts & zero fees are collaborating on Reddit to target them is my new favorite sport. Looks perfectly healthy from where I’m sitting, which is on the bull side :) plus 1 for the little guys.”
And so, smashing the call option purchase order buttons on their smartphones, this new generation of retail investors tap danced emojily over the corpses of the hedge funds’ short positions like so many revolutionaries singing in the pain. This mad revelry did not stop until Thursday when Robinhood, the retail investors’ fintech app of choice, temporarily halted trading on certain securities, GameStop included.
Blue check Twitter, that squally barometer of ill-considered public opinion, erupted in predictable fashion with righteous indignation at this move. The claim, endorsed by politicians who should be sophisticated enough to know better, was that this was just another case of the elites gaming the system in favor of themselves and against everyone else. Such cases do exist, certainly, and it’s a problem, a big problem, but that’s not what happened on Thursday.
Robinhood’s temporary halt was merely a breather they needed in order to satisfy capitalization regulations and clearinghouse rules so they could keep up with the intense trade on GameStop and other bubbling securities. Indeed, after raising $1 billion, getting themselves right, Robinhood opened up trading again, albeit cautiously.
Reporting on what really happened wasn’t enough to stop the conspiracies from spreading, it never is these days, and soon the euphoria generated by frothy markets foamed the fuming lips of those who believed they were being unjustly prohibited from partaking in the gains. The rage intensified.
To understand the anger of the retail investors it helps to consider their demographic and sociological profile. Robinhood users are largely millennials. Things are not going so well for them right now. The economic fruits of the millennial generation are not as bountiful as those harvested in previous generations.
Battered by the second financial crisis of their lifetime, living through a once-in-a-century pandemic during their prime working years, suffering under the yoke of stifling debt, hindered from traditional avenues of capital accumulation by exclusionary zoning regulations, and generally caught in a boomer captured economy, millennials find themselves in a more precarious economic position than the generations of Americans who preceded them. They’re pissed.
They’re pissed because it seems to them that the political class, largely boomer, exists solely to preserve and protect the American establishment, also largely boomer, at the expense of everyone unlucky enough to fall outside of that privileged preserve. How else to explain why in 2008 the investment banks got bailed out while now it feels as if there are no bootstraps to grasp at as many millennials slide further down the slippery K leg of this recovery? Naturally, looking up at the continued rise of members of the financial establishment, the millennials find themselves living in what writer Panjak Mishra calls an age of anger. It’s not surprising that given the opportunity they’d lash out at those they perceive to be their foes with whatever weapons might be available.
What is surprising is that those weapons turned out to be zero-fee margin accounts on fintech apps.
Armed with these simple tools — tools funded with capital seeded by the very boomers they were about to go to war with — a legion of millennial retail investors, launching the opening salvos in a generational war, unleashed a storm of chaos upon financial markets last week the likes of which the world has rarely seen.
WHICH WAY THE REVOLUTION?
Opinions differ, but a popular take is that last week’s retail investor rebellion is the financial world’s equivalent of the French Revolution. One can see the resemblance, at least on the surface. Wall Street is the Ancien Régime and the redditors on WallStreetBets are the rising rabble. One side seeks to preserve its status as hegemon, enjoying exclusive access to the promises of financial modernity. The other side, armed with their ressentiment and fintech weaponry, rallies together with revolutionary zeal under the banner of the democratization of finance. This move was bound to happen. The digital era, after all, has already fundamentally changed the music, movie and media industries. It was only a matter of time before it came for finance.
But revolutions, we must not forget, hold both promise and peril.
On the promise side of the ledger we can already see some positive developments. To begin with, the democratization of finance, of which Robinhood plays only a part, has attracted many new market participants into the finance game. These new players are a beneficial addition to financial markets. “Retail investors,” writes Jennifer J. Schulp, Director of Financial Regulation Studies at the Cato Institute’s Center for Monetary and Financial Alternatives, “should be recognized as important market participants. Like their institutional counterparts, retail investors provide market liquidity. The fact that retail investors behave differently from institutional ones, and sometimes behave differently from each other — far from being a bad thing — can be valuable in times of market stress. Having diverse strategies represented in the market can cabin wild market movements by decreasing herd behavior and allowing better matching of buyers and sellers.”
The networked nature of this fintech revolution also means that financial power is now more decentralized than ever before. We can reasonably expect this Hayekian development to yield more efficient and productive markets. In fact, we’re already seeing evidence of this. Robinhood traders, to take just one example, timed the tanking of last year’s market collapse better than most.
Most importantly, cash rules everything around us, many people are making money.
The peril, however, is that new investors will end up taking big losses, particularly on the GameStop trade. Make no mistake about it: GameStop is a classic financial bubble. Its current valuation is completely divorced from reality. Its meteoric rise is fueled by sentiment, not business fundamentals. When the bubble pops, and it certainly will, those diamond-handed fools who don’t get out before the crash will learn the hard way that their moonshot is really more Space Shuttle Challenger than Apollo Program. It’s going to be ugly.
This isn’t to say that what the GameStop Gamma stonkers are doing is wrong or illegal. They should be free to trade and so far as I can tell they do not run afoul of any securities law or regulation. But their weaponization of financial instruments could give truly nefarious actors some bad ideas. One can easily see the opportunities for malefactors to gather on encrypted messaging apps to illegally coordinate some foul DDoS style attack on financial markets, seeking not profit but disruption of the global market-based capitalist order. That wouldn’t be good for anyone.
To guard against the perils of the retail investor revolution it is worth considering the arguments made by an eighteenth century Member of British Parliament who prophesied the Reign of Terror even before a single drop of blood had stained the hands of the Committee of Public Safety. That MP’s name is Edmund Burke and his warning of what happens to a society when it breaks with its traditions is just as apropos for the participants in today’s fintech revolution as it was for the people building the First French Republic.
In 1789, just after the fall of the Bastille, a French aristocrat wrote to Burke asking his opinion of French current affairs. It’s likely that the aristocrat expected Burke to have something encouraging to say. After all, Burke was a Whig liberal and was on the record as supporting the American cause against British colonial policy.
For Burke the American grievances were rooted in inherited tradition. The colonists were merely asserting their rights as British subjects. The French, however, with their overthrowing of the monarchy and the canceling of the Catholic faith, had gone too far. Nothing but violent upheaval, Burke thought, awaited a people so completely untethered from their cultural inheritance. He argued that a people’s traditions hold within the “collected reason of ages” and were therefore more wise than any single individual who “had never experienced a wisdom greater than their own.”
In language seemingly tailored to appeal to today’s new retail investors Burke wrote that the stock of reason in any one man is vanishingly small so individuals “would be better to avail themselves of the general bank and capital of nations and of ages.”
Last week’s blow up of the hedge funds announced that we are indeed in the midst of a financial revolution. The goal of the revolution should be to take us all to a place that is more open, inclusive and prosperous than the world that preceded it. The fintech apps and their democratization of finance can help get us there. Regulators should not overreact to the market turmoil of the GameStop trade. It will pass. Instead, lawmakers should do all they can to ensure that the regulatory environment encourages frictionless entry into financial markets. The more the merrier. New entrants, meanwhile, should heed Burke’s admonition about the dangers of radicalism. They should study the classics of the investing literature and apply those lessons to each of their trades.
Prudence over propaganda of the deed: Wise decisions grow your wealth, reckless ones get you wiped out and nobody wants to be a loss pornstar.
After all: YOLO.