Short squeezes and market makers

Lesson in Course: Medes Newsletter (advanced, 7min)

What happened in the GME short-squeeze? How does a gamma squeeze work?

It’s been an absolutely incredible morning. $GME hit highs of $144 per share, and NYSE halted trading six times so far this morning. The majority of investors holding a long position in GameStop are looking at massive tendies (capital gains in the lingo of /r/WSB). To give context, GME was trading around $4 a share in late July of last year.



Spurred largely by the Reddit group /r/WSB, retail investors piled into force a short squeeze on institutional investors in a transfer of wealth that would make Occupy Wallstreet proud. Jim Cramer, stock guru for the boomer generation, even weighed in, saying that retail investors bullying hedge funds will be a new paradigm. In your head, you might be wondering how do average Joes take on billion dollar positions held by hedge funds? There is a dearth of resources out there that explain this, and I’ll attempt to break it down for everyone.

The squeeze

Let’s first start by covering briefly what a short squeeze is and how it came about. Bloomberg recently wrote an amazingly detailed piece on how four Reddit users managed to topple Wall Street.

The skinny

I’ll quickly break down the need-to-know details for those who don’t have time to read nor have access to a paid Bloomberg account. The story started over a year ago when u/delaneydi posted in WSB about his thesis for $GME.

/r/WSB GME investment thesis

This didn’t garner much attention at first, but then Michael Burry, famous for shorting subprime mortgages in the Big Short, started taking a large position in $GME and urged management to buy back shares. This was the start of the catalyst for a narrative shift—I’ve written about narrative shifts here for $TESLA, $TWLO, and Bitcoin.

A second Reddit user, /u/Deepfuckingvalue, started to become the prominent champion for GameStop, and he called out Michael Burry’s position. DFV continued to buy call options on $GME over the next months.

(Spoiler as of two days ago, DFV has managed to bag over $10 million in tendies on $GME)

A third Redditer appeared with the name /u/Senior_Hedgehog calling out the short interest on $GME and a short squeeze opportunity.

An investor can short a stock by paying a fee and borrowing stock from a broker. The shorting investor will then sell the stock at the current price and promise to return the borrowed stock by repurchasing it later. In this example, if the hedge-fund borrows 100,000 shares of $GME at $15 per share and sells it today, that’s a cash gain of $1.5 million. If $GME is trading at $8 a share, then the fund only needs to spend $800,000 to buy back the 100,000 shares—bagging a profit of $700,000 minus the fees the brokerage charges to lend the shares.

Shorting only works if the stock price goes down. However, if the stock price goes up to $100 a share, the fund needs to repurchase 100,000 shares back at $10 million, resulting in a net loss of $8.5 million in addition to fees. The danger of shorting is that a stock price has no theoretical ceiling. The stock could (very unlikely) trade at $1 million per share or more, resulting in an infinite potential loss. This is really important to note because the risk described is what causes a short squeeze.

The fat

On September 19, 2020,/u/Player896 pointed out that many short positions were underwater, and margin calls were eminent.

A margin call is an insurance the brokerage puts in place to lend out their shares. If the stock price skyrockets, the hedge fund needs to continue to increase its cash position to prove that the fund can buy back the shares at the current market price. In many cases, the brokerage will limit their own potential loss by automatically closing out the short position if it’s unclear the investor has enough to cover a margin call. Closing out a short position is the same as buying back the underlying stock. /u/Player896 was hinting that if the stock price can be buoyed up, the margin calls will result in automatic buy-backs of shorted $GME shares resulting in massive appreciation.

What most emerging investors don’t know is that a single share can be shorted multiple times. In that screenshot above, GME’s short interest is 120%. Here’s an example of how short interest can be over 100%. Let’s assume the broker lends 100 shares of GME to HF1. HF1 shorts and sells those shares. Those same shares can now be lent to HF2, which also decides to short GME. In this case, the original 100 shares created a short position of -200.

The squeeze

The narrative shift was helped by Ryan Cohen, founder of pet supplies company CHEWY, taking a 5.8 million-share stake in $GME. However, the remainder of the story becomes no longer that of a turn-around business.

War on Wall Street

In a rallying cry, Robinhood users lived up to their name by pledging to seize money from the rich and distribute tendies to the needy. $GME is no longer a company that sells games but a weapon to fight the rich.

For emerging investors on the sideline, the rapidly appreciating stock price was too good to pass up. Even if they didn’t stand with the anti-capitalistic mob, FOMO watching everyone rake in tendies resulted in them joining in.

Market Makers and OTM calls

We’ve gotten to the point where it’s time to answer how retail investors can short-squeeze institutional hedge funds. After all, don’t they have enough cash for margin calls?

Even in a coordinated effort, Robinhood users do not have enough money to move markets by buying the underlying $GME shares. However, Robinhood users do have the courage to take on excessive risk. The brokerage platform empowers users to buy out-of-the-money (OTM) call options on $GME shares. A few hundred dollars can buy a handful of call option contracts that have extremely high strike prices. These contracts alone are enough to move markets. Here’s why.

Market Makers

Market makers exist to provide liquidity to traders. What that means is that when we enter in a purchase or sell order, it’s often a market maker that takes the other end of the transaction. Their entire goal is to make it easier for retail investors to enter and exit positions, and they are compensated for doing so.

OTM calls

As Robinhood users are piling into OTM call options, these market makers are selling those options to the users. While they are selling call options, the market makers also can’t stand to lose money if the stock increases in value. Instead, they hedge their positions by buying underlying stock in $GME so that in the case that the stock prices rise and those call options become in the money, they offset the potential losses with appreciating $GME stock. The important thing to note is that every call contract represents 100 shares of the underlying. For options that cost a few bucks to purchase by the Robinhood user, the market maker needs to purchase 100 shares to offset the risk. As users pile into OTM calls, the market makers end up with massive buy orders of $GME stock enough to move the actual markets and trigger a short squeeze (aka gamma squeeze). As shorts get margin called and their positions are closed out, more retail investors pile in on a hot stock, which quickly spirals out of control.

Capitalizing on the chaos

As everything started to unfold this morning, savvy investors realized that an artificial intra-day bubble was forming due to the feedback cycle above. The stock price was not sustainable. As $GME was trading over $140 per share, investors were buying up as many put options to bet against the stock price as possible. For a brief moment, both the stock price and put option prices were up simultaneously, which goes against the typical relationship put option pricing has with the underlying—usually a sign of unhealthy markets.

zerohedge on Twitter

How insane is everything? OTM GME puts are up today

As of now, the stock price is trading at half of the highs of today. Hopefully, if you had call options in $GME, you cashed in your tendies before the implied volatility crush.