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Blog - Short Squeeze / Gamma Squeeze Explained
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GameStop went to the MOON
Every once in a while something will occur in the market that will just make you shake your head and mutter under your breath “I can’t f*****g believe that just happened”. In 2020 alone there were multiple occasions where I did this not just in normal life but also in the market. Back to back limit down red days that broke circuits left and right will cause this sentiment. Well, the past few days another incredible event occurred.
I’ll let this graph by YCharts spell it out for you.
If you haven’t heard, Gamestop $GME is all over the news. To break down how Gamestop was trading at $17.24 on January 4th and less than a couple of weeks it hit a high of $159.18 we need to dig through the debris, memes, and just overall noise of this phenomenon.
Origin - r/WallStreetBets
The only accurate way to cover what happened (and what is currently happening) we need to go over what specific group was behind this price action. On Reddit is a group called WallStreetBets that are essentially (for a lack of a better word) degenerate traders who have oftentimes banded together (all 1.9 million of them) to buy/pump a stock. It is almost barbaric the way they trade at times - wearing their massive losses as medals alongside their wins. We aren’t just talking about a couple of thousand-dollar accounts here as well. Wallstreetbets can move some serious money and the past couple of days proved that. Here is an example of prime Wallstreetbets content.
Catalyst - Citron Research
In every trade, there is a winner and a loser. The big losers were Citron Research and Melvin Capital (Hedge Fund) which are notorious for short selling. If you don’t know what short selling is hold your horses I will get to it later in the newsletter. Citron’s leader? Andrew Left. According to Wikipedia he “is an activist short seller, author, and editor of the online investment newsletter Citron Research, (…) Left publishes reports on firms that he claims are overvalued or are engaged in fraud. Left is known for advising investors on short-selling”.
In January, GameStop announced a complete overhaul of the board of directors which caused the price of the stock to have a massive pop. Left came out publicly airing his short position and listing reasons why he thinks the price of GameStop will fall over 50% back to $20 a share in this youtube video. I am more than confident he regrets posting this.
Little did Andrew know he woke a sleeping giant and his video only added fuel to the fire. WallStreetBets went ALL IN on GameStop stock in an attempt to push out Citron’s/Melvin/ and other firms short positions. Left called what happened the following days as an "angry mob who owns this stock has spent the past 48 hours committing multiple crimes". We will let you decide if you think he is right or not but there’s still a lot more to unpack here and big learning lessons. As Left threw more insults towards WallStreetBets the stock kept climbing. What caused this? Two market phenomenons caused this massive price action and I will explain as simply as I can below.
1) Short Squeeze
Gamestop stock only a couple of months ago was $4 a share and the other day it broke $159. Their target was $GME and their mission was complete. What happened was called a “short squeeze”.
Let me explain.
You can buy shares of a company or you can “short” a company (bet that it will go down).
Shorting has an unlimited downside since the stock could technically go infinitely up and has a limited upside since the stock can go only to zero. In essence, when shorting a 50% gain is considered a home run.
When you short a stock you are actually borrowing stock that you don’t own from the broker. Immediately selling that stock on the market. Then waiting for the price to drop. When the price drops and you want to cash in you buy back the stock from the market and return the borrowed stock to the broker. The difference is your gain.
Let’s walk this through...
I short 1 share of $AAPL at 100. So I borrow 1 share. I sell that 1 share to the market so now I have $100 in my pocket. $AAPL drops to $50 a share. I buy 1 share again (but only have to spend $50 since it’s cheaper) and then return that share to the broker. What’s leftover is my $50 gain!
So with $GME, a group called Citron research announced that they are shorting $GME. Wallstreetbets said no way, we will overpower you and bought, bought, bought. The only way the people shorting can get out of their short positions is to BUY shares causing a snowball effect and the price to rocket - this is a short squeeze.
2) Gamma Squeeze
Not only was there a short squeeze but there also was a market phenomenon known as a gamma squeeze.
To understand what a gamma squeeze is you need to understand what selling a call option is. In the simplest of terms, selling a call or also known as “writing a call option” is when you own shares of stock in a company and you have a neutral to a bearish outlook on the future performance. You believe the stock will not go up to a certain price in “X” amount of time. You collect a premium for selling a call to a buyer of a normal call option! To read more about the selling a call option click here because it would seriously take up the whole email.
Moving along…
Gamma Squeeze: This is the result of many investors buying up options to drive the price of a stock up which causes option sellers to need to hedge their trades thus causing the price to go further up.
What needs to happen (timeline):
1. Need a large investor(s) - In this case basically the entire Wallstreet Bets Reddit.
2. Buying really far out of the money call options. Out of the money means a strike price that is above the current share price. If $GME is trading at $10 an out-of-the-money option or know as “OTM” would be an option contract that has a strike price of $15 for example.
3. The brokers, banks, or short sellers, and/or neutral to bearish individuals that sell these call options buy underlying stock so they don’t have what’s called a “naked call option”. To not fall into the naked call option category that means for every contract they sell they must own 100 shares of the underlying stock.
4. The more the investors (WallStreetBets) buy these call options the more shares the call sellers have to buy to make sure they don’t fall into the naked call option category.
5. The buying by the banks, brokers, etc. to “cover” their calls can thus make the stock go higher and higher, creating a positive feedback loop.
All said and done, this is the basics of a gamma squeeze and truly was a perfect storm for $GME to go to the moon. If you are wondering why a call seller would keep buying shares to cover their calls it’s because a naked call is technically the riskiest option strategy. You have unlimited risk just like short selling but on top of that, it’s leveraged. It can get ugly very fast.
Is the market broken?
My short and long answer is no, it’s working perfectly fine. Actually, this proved for many that the market does work, it’s just not working in the favor of Wall Street (a common term used to describe the big institutions, firms, hedge funds, banks, etc.). Theoretically speaking, if there are more buyers than sellers a price of a stock has to go up. I actually find it hilarious watching Cramer the past couple of days losing his mind saying that the fabric of the market is broken. Give me a break. Retail investors have been dumped on by Wall Street 10000000000000x to 1 when it comes to investing in the stock market. Insanely high IPO releases, dark pools, high-frequency trading - you name it. Wall Street is almost undefeated in screwing over the average joe investor. If you don’t believe me read "Flash Boys” by Michael J. Lewis and you will never look at the market the same. It’s about damn time the average joe has a win in the market. To be completely honest, during this GameStop madness I have been a fly on the wall watching the circus, but part of this incredible short squeeze reminds me of Rudy Ruettiger.
Maybe WallStreetBets won one for the Gipper after all?
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I dined hedge fund manager today, and I'm going for seconds tomorrow. As I write this, GME sits at 218 and rising. This is payback for 2008. These people cost me my job back then, and I'm going to make certain sure Citron is ruined by the end of the month.