For ages we’ve all heard how retail investors are the suckers when it comes to trading the stock markets and how they get chewed up by the big hedge fund guys.
Well, 2021 may just prove this all wrong.
Let’s just get into it.
Gamestop is a company that sells video games from its brick and mortar stores. It has, in recent past, struggled with competition from online digital platforms such as Steam, and the like, making it a fundamentally weak business to own.
The weak business fundamentals invited the attention of some major hedge fund players, who decided to short the said stock, considering the poor business parameters.
However, the short didn’t last for too long, after the surge in prices forced these players to sell.
Who was responsible: r/wallstreetbets (WSB)
The “novice” traders at WSB, after reading up on the short positions, decided to ride the opposite of the trade with long call option trades, and went on to “YOLO the trade”, which basically meant go all in.
Say, if you borrow a stock from a friend and sell at 100 with hopes of covering it at 80, you make a profit of 20 and then return the stock to your friend. That’s the system of shorting stocks.
Now the hedge funds are short by borrowing the stock, so technically, their loss potential is infinite.
Loss potential is infinite, because if you sell at 100, the stock can go up to 200, 300, 500, 1000, etc. There isn’t a fixed loss here.
Long Call Options:
What did WSB do?
Instead of going long on the stocks directly, the WSB traders ended up buying cheap call options for the GameStop instead.
Who sells these call options to them? Another major financial institution aka the Suits (as coined by Dave Portnoy).
These institutions sell call options (bearish trade) and to manage risk, they buy certain stock of the same company as well (bullish), in case the stock surges. That is effectively the job of the market makers.
Now the call options and stock price do move in similar directions, but they do not go up by the same amount. If the stock price goes up from 100 to 105, say, the call option with a strike price of 120 may go up by just 1 rupee or so. That is why if a market maker sells 100 call options, he will buy, say, only 30 shares.
Without getting into option Greeks, Deltas and Gamma Squeezes, the important thing to know here is that as the stock price begins approaching the strike price on the call options, the movement becomes more linear.
So, if the stock price goes from 120 to 125, there is a high chance that the call option with a strike price of 120, would go up by close to 4-5 rupees, as well.
Basically, this means, the more the price appears closer to the strike prices of options, the market makers are required to buy more stock against the short call options. This leads to buying the shares and increases price.
Who does this hurt? Yes, the people who have short positions.
This is known as the short squeeze.
And that’s what caused the major problem.
If you have successfully made it this far, you probably already understand what happened.
Heavy option buying by retail traders lead to a huge demand for GameStop shares by the market makers (to hedge against their short calls), leading to surge in prices of the stock and hurting the Hedge Funds who were short.
The questions from this are plenty.
Are Hedge Funds screwed? Will brokers side with deep pockets? How influential can retail investors be when pooled together against the big guys? How much of what they both do (WSB and Hedge Funds) is actually regulated/ legal?
Only time will tell, but history hasn’t always been kind on the retail traders.
For now, the WSB community seems to have the moral backing of a few biggies such as Mark Cuban, Chamath Palihapitiya and Dave Portnoy who have publicly come out in support of what the reddit community does.
Ending this explanation, with this interview with Chamath, which is an absolute must watch.