GameStop: From Rags to Riches
For about a week, Gamestop corp (GME) has continuously been in news. From the open of about $38 on Jan 15, 2021, it hit a high of $380 on Jan 27, 2021. What is driving this rally and why is the stock earning so much attention? This has less to do with the fundamentals and more with the pledge of a few members of reddit group r/wallstreetbets to get revenge on wealthy wallstreeters. Let’s see what happened.
First a little background. Gamestop owns and operates about 5509 video game stores across the US, Canada, Australia, New Zealand, and Europe. The company has been struggling since the online game services from Xbox, PS, Nintendo switch and steam have become popular. The footfalls were reducing and then came COVID to make the bad worse. So overall, considering the business model and changing consumption patterns, company was not supposed to turn profitable anytime soon.
This was the reason many hedge funds at wall street bet against the company and short the stock.
{What is shorting means you ask? Those of you who know about shorting can skip this part, others may read on. Suppose there is a guy named Raju. The monsoon this year has been great, and Raju thinks that rice will be produced in abundance. This means that due to the logic of supply > demand, prices of rice will fall compared to what they are right now. He goes to Baburao, who has some rice produce with him, and asks him to lend him a sack of rice. He promises to replenish the rice at a future date and pay a small interest.
Raju goes to market, sells the rice at current price of 200, crosses his fingers and hopes the prices to fall. What he thought comes to pass and the prices fall to 100. Raju buys the rice at 100 returns them to Baburao with an interest of let’s say 10%. So Raju earns Rs 80 (200–100–10% of 200) by speculating on price fall. If however the prices were to rise, Raju would have had to buy it at a price higher than 200 and hence incur a loss. And theoretically, prices can rise infinitely and hence there is no cap to loss in a short. This is the reason only seasoned investors enter into huge short positions. Replace the rice with shares, you have the shorting mechanism of stock market.}
But this time, a bull trend (upward movement) in the stock was about to happen, thanks to people in the Reddit group r/wallstreetbets (WSB). About two years back, some people in the group shared their long position giving the premise that the currently company’s shares are undervalued even if we were to simply see the cash reserves (The book value of the share was about $19 on Jan 31, 2019 while it was traded at $11.25 on Feb 01, 2019). But nobody cared.
In Aug 2019, Michael Burry announced that he held a 3% stake in the company. For those of you who don’t know Michael Burry, he was played by Christian Bale in the movie ‘The Big Short’. Still, for about a year, there were no major price movements in the stock. However, in the end of Aug 31, 2020, Ryan Cohen, co-founder of online pet supply retailer Chewy, disclosed that he bought a 9% stake in Gamestop. The share finally shot up 40% in one week.
All this while, some members of WSB kept buying GME shares and GME call options and kept making money.
{Now what is a call option? Those who already know, skip the next three small paras. Assume that you are a dairy product manufacturer. Your main raw material would be milk of which the current price is 30/liter. Suppose due to some reason, you think that prices of milk may rise in future. You want to lock a price at which you can buy milk in the future. But you also want that if prices don’t rise, you should be able to buy milk at the then prevailing market price.
So you go to a dairy owner, Lallan, and enter into a contract for 20 days with him to lock a price of 31, with a condition that you will buy only if the price after 20 days is >31. Lallan says that as he is bearing a risk and there is no chance of reward for him (if price <= 31 you don’t buy and if price >31, you buy at 31 in which case Lallan’s loss will be market price — 31), he wants some compensation. You pay him some fix amount of Rs 500 and wait for 20 days to be over. After 20 days, your loss can be a maximum of Rs 500 and you will have saved yourself a lot of sleepless nights.
Lallan is the market maker here, Rs 500 is option premium, 20 days is the duration, Rs 31 is the stike price, milk is the underlying and the market price after 20 days is spot price. So essentially, call option gives you right to buy the underlying at strike price if you wish to. If not, you can ignore it. Simple.}
All this led to building of stock momentum and given the liquidity with the traders right now, they started jumping in. This in turn increased the prices. Now if you are a shorter or the writer/market maker of a call option, you will be worried about this. You will also be worried that the prices may rise even further adding to the losses. So, to close their positions, shorters started to buy Gamestop which further fueled the bull which made more shorters uneasy, who further bought the shares, and round and round they went. This phenomenon where bulls forced shorters to exit their position is called ‘Short squeeze’ (the term that you must have read in some of the headlines also). Ryan Cohen also got a board seat in gamestop a few days back and perhaps people saw a turnaround. Chamath Palihapitiya’s call position and Elon musk’s tweet also helped drive the prices up.
There was one more phenomenon at work here. If you are a market maker (you have sold a call option), you are incurring a loss as the prices move up. So, what do you do to cover you losses? You buy the underlying shares in the market. So, when price goes up, your call is in loss but underlying will give you profit offsetting that loss. However, buying the underlying requires huge sums of money (a bundle of 30 shares @ 1000 each in spot market will cost you 30K while a bundle of same quantity will earn you the premium). If you are expecting the prices to fall, you will sell the call options in huge quantities and would need huge capital to cover the position in spot market. So as the prices increased here, sellers of call also started buying Gamestop shares and this again fueled the bull. This here is ‘Gamma squeeze’ (the name is derived from gamma ratio which is a rate of change in option delta. More on this here).
And now, the situation is a tug of war between the people who are long and who are short on the stock. The prices will literally move to the side where weight is more (because that will steer general public’s opinion of whether the prices will fall or rise). Just so you know, as on Dec 31,2020 for every share of Gamestop available in market, 2.6 shares were short. That means 2.6 shares were borrowed against one share and shorted in the market. People were short more shares than the company had issued. OK I should stop now.
So this was how it went down. If you wish to read more, below is a detailed article (with Reddit usernames and screenshots). The financial info was from Yahoo finance and the share prices were from NYSE. Cheers!
