GameStop: Power to the Players
How a struggling video game retailer became the battleground between Wall Street and Main Street.
GameStop is an American video game retailer that has been struggling, to say the least, for the last couple of years. In the world of online gaming and e-commerce, the company has failed to keep up with the times, and its business model, selling physical video games, is becoming obsolete. To top it off, amidst the Covid-19 pandemic, the company closed 462 stores in 2020 alone and it is expected to close another 600 by the end of March.
The company’s stock (GME) tells another story. It has soared to record highs since the beginning of 2021. Gaining nearly 2000% in this year alone, the stock reached an all-time high of $483 on Thursday after popping almost $200 higher just the day prior. While GME’s performance is astonishing, even its run-up in price has not been uncommon with increasing market volatility. Most recently, Hertz (HTZGQ) and Kodak (KODK) saw enormous upticks in their value during the pandemic. Speculative investors poured into these insolvent companies hoping to gain lucrative returns. Many took to online discussion boards such as Reddit’s r/WallStreetBets to share their successes and failures. This week the wild frenzy surrounding GameStop reached a boiling point with Reddit’s self-proclaimed “degenerates” feuding against Wall Street’s elite — making it the most talked about stock in the world.
Skin In The Game
r/WallStreetBets — Like 4chan found a Bloomberg Terminal
The story of GameStop’s meteoric rise began in a Boston suburb in September of 2019. Keith Gill, a Redditor and video-streamer, posted to r/WallStreetBets that he began to purchase long-dated call options of GameStop with his broker. This gave him the opportunity, but not the obligation, to purchase the shares of GameStop at a set price of $8 up until January of 2021. At the time, GME was trading at just over $4. Keith took a chance on the gaming retailer and made a bet that GameStop’s share price would more than double by the start of 2021.
Over the next year, GME’s stock remained relatively flat and in the eyes of the masses, the chance of these call options ever turning a profit looked slim. Other Reddit users mocked Gill saying that the bid-ask spreads, the difference between the cost of buying and selling each of his options, were too large.
“You could land a (Boeing) 747 between the spread on these. Possible no one will even buy these at the mid. Sell now”
Undeterred, Gill had faith in his investment and continued to hold out. What nobody noticed was that for a company with an obsolete business model, GameStop was still in a solvent financial position and had enough cash on hand to pay off its debt. More importantly, the short interest (more on this later) on GME was over 100% of the stock’s actual value and growing. Enter the Suits.
The Wall Street Suits
If you are a fan of Barstool Sports and their founder David Portnoy, you are probably familiar with this term already. Portnoy coined it back in March of 2020 when Covid-19 shut down all sporting events and he took up day trading stocks as a substitute for sports betting. The Suits are those sleeping in their penthouses on Park Avenue and are chauffeured to their hedge fund offices every morning. They are supposedly the brightest minds on Wall Street and make billions and billions of “smart money” each year.
Hedge funds are notorious for investing other people’s money and charging fees based on their performance. They specialize in identifying opportunities that can grow their investors’ capital and “hedging,” manage the amount of risk, against the potential downside of these growth prospects.
Hedge funds are highly leveraged, or in simpler terms, this means that they can invest more money than they have. Think of it as a seesaw, depending on how much leverage you have or how close to the center of the see-saw you are, you can move much heavier objects on the other side. Having higher leverage means that you can move more with less, and in the case of some hedge funds, they have upwards of 15x leverage. If a fund has $10 of capital, they can borrow and therefore trade $150.
If this amount already seems large, we have yet to take into account net exposure. When you trade you can either buy or sell stocks. When you buy or go long on a stock, you believe the stock has more value. On the flip side, you can sell or be short on a stock and bet that its value will decrease. Specifically, if a fund has gone long on $150, they can still invest another $150 but only by going short. By investing in both directions, the net exposure of a hedge fund is considered to be zero (+$150 summed with -$150) and it is deemed to be safe. Investors prefer net exposures close to zero and provide more capital to these funds as a “safe” investment. However, this means we have turned our measly $10 of capital into $300 of investment power — $300 is still at risk.
Wall Street vs Main Street
The Big Short
As mentioned before, shorting a stock is betting that the price will fall. To execute this trade, an investor must borrow the share from someone who already owns it. Your stockbroker will immediately then sell this individual’s share and give you the proceeds. You need to return the share to whoever you borrowed it from; so you wait for the stock’s price to drop in the market. Once this occurs, you can buy back the share at the lower market price and keep the difference as your profit. Finally, you would return the purchased share to its original owner to complete the trade.
The idea behind short sales is intuitive but the risks involved with them are much greater. When you buy a stock, there is a slim chance that it will bust and go to zero. However, you will only lose the amount of money you initially invested — this caps your losses. If you short a share, your profit is capped at 100%, but you can lose an obscene amount of money if a stock’s price continues to rise. You will eventually have to repurchase the share at a much higher price to close out your position and your losses can theoretically grow to infinity if the share price never drops.
GameStop has been the target of many hedge funds for quite some time now. These funds have accumulated large short positions using their high leverage ratios to pool investor money and bet against GME. The most notable bears include Melvin Capital, one of Wall Street’s most successful hedge funds, and Andrew Left’s Citron Research. As of September 2020, Melvin Capital disclosed to the U.S. Securities and Exchange Commission (SEC) that their short position in GameStop consisted of 5,400,000 shares at an average cost of $10.20 totaling $55,080,000 in value.
Time for a Squeeze
Kevin Gill picked up nearly a year ago that the floating short interest of GameStop was over 140% of total shares. How can you sell more shares than there are shares in the first place? It goes back to the short-sale transaction itself.
As an example, take a situation involving four investors. Annie owns shares of GameStop, and Annie and her broker have an agreement that allows the broker to lend Annie’s shares to short-sellers. It lends them to Bob, who subsequently sells those borrowed shares short in hopes that GameStop’s share price will fall.
An investor named Chris ends up buying those borrowed shares from Bob. However, Chris has no way of knowing that those shares have been borrowed from Annie. To Chris, they’re just like any other shares.
More importantly, if Chris has the same kind of agreement, then Chris’s broker can lend out those shares to yet another investor. Diane, another GameStop bear, can borrow those shares and sell them short.
The independent firm S3 Partners tracks short interest (SI) and even by their most conservative estimates, adjusting for synthetic long positions (an option strategy that mimics buying a stock) the short interest for GameStop was 58.3% — making it the most shorted stock in the market by float percentage.
It’s impossible to know the exact short interest of GameStop but many Redditors took notice that with 75% of GameStop’s shares potentially locked up by the company’s board members, C-suite executives and pension funds, the real short interest on float (the shares that can be actively traded) could be well over 200%.
Another Reddit post surrounding GameStop began to start trending.
Sup gamblers. Feel bad about missing the gain train on TSLA? Fear not — something much greater and stupider is here.
You know Citadel? The MM (market maker) that took all our money today? Well now we finally won’t be at the mercy of the MMs. Instead, we’re going to temporarily join forces with the Galactic Empire and hijack the death star.
Our choice of weapon… $GME.
This Reddit user made his case for GameStop; outlining two prominent shareholders. Billionaire Ryan Cohen, who sold the online pet product retailer Chewy in 2017 for $3.3 billion, had disclosed his significant holding in GameStop and now sat on their board of directors. Cohen had experience as an ecommerce mastermind and proved that small retailers such as Chewy could compete with the Amazons and Walmarts of the world. In addition to Cohen, the famous investor known for predicting the 2008 housing crisis, Michael Burry, had discovered that 90% of GameStop’s stores were free cash flow positive before COVID and invested. He too had skin in the game.
More and more Redditors began to pour into GameStop and its stock started to tick upwards. In 2020, GME doubled from $4 to $8 in September, doubled again to $16 by October and again to $32 by the second week of January. Seven days later, it was $64.
Now even the most successful shorts who bet against GameStop at its peak before the 2008 recession would have been sitting on a losing position. Last Friday, Melvin Capital’s short position was down over $290 million and the army of Redditors smelled blood.
Short sellers eventually need to cover their positions and return their borrowed shares. With the short interest at over 140%, hedge funds betting against GameStop need to purchase more shares than there are in the company to pay it off — that means purchasing at any price. Funds trying to cover their losses are required to buy hundreds of thousands of shares which only pushes the price up further causing a short squeeze.
A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to forestall even greater losses. Their scramble to buy only adds to the upward pressure on the stock’s price.
The pressure was on for the funds to minimize their losses while thousands of Redditors stood their ground against them. What began in a niche Reddit forum had spread like wildfire online. #HOLDTHELINE and #DIAMONDHANDS trended across social media giving a clear sign to Wall Street of the unwavering determination in everyday people looking to hold their positions in GameStop.
Last Friday, thanks to momentum and growing interest from retail traders, things turned up a notch and a gamma squeeze occurred on top of the short squeeze already in play. One of the by-products of r/WallStreetBets has been the popularization of trading stock options by retail traders.
A stock option is a derivative that gives you the right to buy or sell 100 shares of stock in the future at a set price. The price you have the right to buy or sell it at is the “strike price.” The option has an expiration date. It also can be either a call option (which gives you the right to buy the stock) or a put option (which gives you the right to sell it).
One factor that impacts an option’s price is gamma, it is used by market makers (high frequency trading firms such as Citadel Securities) to figure out how to hedge their bets. The higher the gamma, the larger a stock position the market maker will need in order to have an effective hedge against open options positions. As a result, as gamma changes, market makers with open options positions are often forced to buy or sell the underlying stock to keep their own books properly hedged. Large amounts of that forced buying or selling activity is what creates a gamma squeeze.
With the soaring share price of GameStop over every available call strike, market makers scrambled to buy millions of shares to deliver them. In after-hours trading, to close out the week, GME reached a record high of $93. The next trading day on Monday would see the stock soar to $144 before plummeting back down to $69 and then creeping up to $95 before markets closed. The stage was set for a tug of war over GME’s stock price between Wall Street and Main Street.
Bring Out The Big Guns
Once mainstream media took notice, things began to get out of control. More people than ever before piled into GameStop. It wasn’t just retail investors getting in on the action. On Monday Chamath Palihapitiya, CEO of Social Capital, announced on Twitter that he would be buying $100,000 worth of calls with a strike price of $115. That level was reached in less than 24 hours, more than quadrupling his initial investment. Then…
This one word tweet from the wealthiest man on the planet, Elon Musk, shot up GameStop’s share price 125% to open at $327 Wednesday morning. The short sellers were treading in deep water and everyone knew it. Kevin Gill posted that he had exercised his initial position and his profits had grown to over $45 million. The hedge funds were not as lucky, Melvin Capital’s loss quadrupled to approximately $1.7 billion dollars, before the addition of fees.
With short selling, you pay a borrowing fee for the shares that can change day-to-day (similar to interest on a credit card). When someone short sells a stock that is already heavily shorted, they have to pay a fee to borrow it. During this week the fee for GME fluctuated between 20%-80% and hovered around 30% intraday. The longer you hold onto a short position, the more it costs. Eventually it either costs too much and you have to close your position for a loss, or risk bankruptcy. Reports emerged that Melvin Capital was down 30% year-to-date from their short investments. With approximately $12.5 billion of assets under management (AUM) at the start of 2021, their loss topped $3.75 billion.
Going back to our earlier example, where a fund levered up their $10 of capital into $300 for investing, banks take notice about whether you have enough credit to cover your position. When losses become too large, lenders demand that you put up more collateral, the assets that are given by a borrower to a lender in order to secure a loan, to back your $300. Hedge funds scrambled to offer up collateral on Wednesday and we saw drops in the prices of major companies which these institutions had large stakes in. The overall market sold off as the large funds covered other short positions and unloaded their other long positions.
Citadel Securities and Robinhood
The Redditors were not the only ones to profit from GameStop’s rise. With new investors jumping to buy shares, commission-free trading apps saw a surge in account activations. One app popular among the retail crowd is Robinhood. Robinhood is a stockbroker, but they don’t execute stock orders themselves. Instead the company routes customer orders to much larger market makers that have the infrastructure required to make high-frequency trades. Citadel, the massive hedge fund founded by billionaire Ken Griffin, owns the primary market maker for Robinhood. Citadel Securities, the market maker, pays Robinhood a predetermined fee for every trade they execute in an arrangement known as payment for order flow (PFOF).
As a broker Robinhood is obligated to provide its clients with the best execution on their trades. This means they are obligated to put their clients’ interests first, and try and get either the best price or fastest execution. Robinhood traders generally do not buy or sell options in large quantities so Robinhood sends their aggregated trading data to Citadel Securities who groups the individual trades from multiple orders into lots, batches of 100 before trading.
Market makers profit from these arrangements in a few different ways but in the case of Robinhood, Citadel Securities would take a portion of the spread at which the trades are executed. Citadel accounted for 55% of Robinhood’s total order flow earning $60 million alone in the fourth quarter of 2020 from PFOF fees.
While the market making arm of Citadel handled Robinhood’s orders, the hedge fund itself stepped in from the sidelines. With Melvin Capital caught up in the GameStop short squeeze, it was reported by the WSJ Monday that:
Citadel LLC and Point72 Asset Management are investing $2.75 billion in hedge fund Melvin Capital Management, an emergency influx of cash that is expected to stabilize what has been one of the top performing funds on Wall Street.
Citadel now appeared to be in on both sides of the GameStop fiasco. On one hand, it was executing thousands of Robinhood trades through Citadel Securities, while on the other, funding capital into the hedge fund shorting the very same stock. If the optics didn’t look bad already, Point72, is led by Steve Cohen. Cohen’s former hedge fund, SAC Capital, was the firm that pleaded guilty to insider trading in 2013. Furthermore, Melvin Capital is run by Gabriel Plotkin, one of SAC Capital’s top traders.Despite the collective efforts of these Wall Street firms, GameStop stock surged on.
A Life Line
“In the interest of mitigating risk for our clients, we have temporarily placed GameStop…in reduce-only mode.”
This was the message Robinhood users received on Thursday. Their brokerage had prevented trading of GameStop’s stock, but only in one direction. Robinhood had changed their restrictions overnight and made it such that traders could only sell their positions in GameStop stock. This created such a one sided pressure on GME that after surging to $483 in the morning, the stock tumbled over 70% intraday before closing down 42% for the day. Robinhood, the app named after the hero who stole from the rich to give to the poor, had turned their backs on the little guys.
Was this a decision made by the individual brokerage? Were the regulators involved? The Robinhood’s CEO, Vlad Tenet, tried to clear the air on CNN on Wednesday when markets closed.
Bloomberg reported on Wednesday that the company had drawn on its credit lines and the company quickly released an official statement before the weekend to explain the situation. The conflicting messages with Tenev’s interview left many questions up in the air. Social media exploded over the company’s decision and conspiracy theories of whether Wall Street hedge funds were involved emerged. Dave Portnoy, who personally risked $2 million into GameStop during its rally, took to Twitter to rant about the “crime” that had taken place. People wanted answers.
A Possible Explanation
When you buy or sell a stock, Robinhood sends your orders to market makers (Citadel Securities) to execute your trades. These market makers send a record of transactions back to Robinhood, which works with a clearinghouse to record the trade.
Clearinghouses are SEC-registered organizations that act as the central depository for securities. They keep a record of the stocks owned through a brokerage.
Clearinghouses establish financial requirements for members including deposit requirements designed to reduce risk to the clearinghouse. It takes two days for the clearinghouse to transfer the stock to the buyer and the funds to the seller. This is known as “clearance and settlement” and it occurs on the trade date plus two days “T+2.”
During these two days, Robinhood must pay out the net of the share purchases and sales. Since Robinhood doesn’t actually have the shares, they need to synthetically short it to cover it too or else they have to post margin. This is a credit risk for the company.
For a broker like Robinhood, this procedure is normally meant to protect it during standard market trading. However, with the huge influx in transactions being made on GameStop, these deposit requirements changed dramatically with the increased volatility in the stock’s price. The fail-safe had broken for Robinhood and they were now on the ropes.
What is still unknown is Robinhood’s decision to block only buy orders of GameStop’s stock. Some brokers opted into clearinghouse requirements by delayed transactions or halted trading all together. From the eyes of Main Street, Robinhood’s decision was a bending of the rules in favour of Wall Street.
If we are all players in the same game, you cannot stop to change the rules halfway through.
Power to the Players
No one in their right mind believes that GameStop is worth $23 billion. To put it into perspective, BestBuy (BBY), is worth only $28 billion. The Suits on Wall Street would tell you that every fundamental in the book disagrees with the current price level and they are probably right. The company is expected to turn a profit after 2023 even with their new board of directors and Ryan Cohen at the wheel.
However, it is foolish for anyone to believe that these are the only factors to consider when justifying GameStop’s price. The reason GameStop has become so heavily traded has nothing to do with ratios or multiples in an Excel spreadsheet. It is because of the people behind the rally and the times we live in.
The LA Times interviewed dozens of people to see what their motive was for buying GameStop.
“We don’t have a mission to burn down Wall Street”
People have been cooped up inside for too long and are looking for something to do. The simplicity and gamification of trading on apps similar to Robinhood make it easier than ever to trade in the public markets.
“I’m a family man, I have a personal interest to make as much as I can to build my family’s future”
The coronavirus pandemic has left millions of people out of a job and without a steady flow of income, many are trying to earn a quick buck. Unfortunately, these are the individuals that are the most at risk with the turbulence in GameStop’s share price. The house always wins.
“My goal isn’t to get rich on this, my goal is to bankrupt these billionaires”
For decades, there has been a large public disdain toward corporate America and those who sit at the throne. Posts on social media have compared this week to the Occupy Wall Street protests while others say this has been a long time coming for those who manufactured the financial crisis of 2008 and walked away scot-free. The average Joe can finally stick it to the billionaires where it hurts the most — in their pockets.
“It felt good to be investing in something alongside hundreds of thousands of other people”
This final quote sums it all up. As individuals, we have little influence. But as a collective, we can make something come true if enough people believe in it.
In this digital age, information is more readily available for individuals to share ideas. We’ve seen the good and the evil of this influence. This week, a trending Reddit forum grew to alter the direction of the global economy while just three weeks ago, then President Donald Trump’s tweets sparked an insurrection against the US Capitol that left five people dead.
Whether our collective efforts are for the greater good, it is entirely up to us as individuals to pick the side and values that win. Power to the people.