It’s against the vision of this blog to write about single stocks, however GME is one of these cases that give us a lot to learn from.
As Lenin said ‘There are decades when nothing happens and there are weeks when decades happen’. Not quite but it was a lot of action.
I’ll only look into the mechanical side of things and the important takeaways which can inform future trading.
Some would argue that it is easy to comment on past events, and I agree. However, I believe that we can learn from these and become more successful.
It doesn’t matter which side you support, there’s a lot to lose, long or short.
This article covers the retail vs institutions debate, positional advantage, short selling and short squeeze, some economics and the brokers’ position.
Were there any sides and was this a war
There is only one side in the Market and that’s the money. It’s a capital market where you can buy or sell different products like stock, bonds, options, futures, ETFs, even mortgage-backed securities, pick your fancy.
I don’t see any sides to it or a war, these exist only in the media and on Reddit. There’s no emotion either, you click buy and sell on a screen.
Making a position a personal issue can easily blow your account so avoid this like the plague. Sometimes the Market can be like the gym, you only need to beat yourself to win. An ‘I against I’ game.
There were winners and losers on both sides. Some of the retail traders made it big, some lost money. The same goes for hedge funds.
So it’s just the Market doing its thing, creating winners and losers.
Here are the numbers on the short side
Ortex, a data provider, estimated paper losses of $70 billion on short positions as of the end of January. Here are the GME results on the hedge funds side:
|Fund||Loss in $||% of fund||Verified|
|Melvin Capital||6.625 billion||53%||No|
|D1 Capital Partners||4 billion||20%||No|
|Citron Research*||undisclosed, covered at 100% loss||undisclosed||No|
Be aware that the figures have not been verified! It is possible that Melvin haven’t covered the short yet. Hedge funds are opaque and we can’t take Gabe Plotkin’s word for it.
Citadel Securities, a known customer of Robinhood, a US broker, infused capital in Melvin along with Point72. The motivation is unconvincing, so we’re yet to find out if this was just a bit of cash to satisfy margin requirements.
I appreciate that a few billion are breakfast money for these guys but still you don’t throw it at Gabe just because he’s a nice person. I’m sure there’s more.
Either way this is a trading strategy straight out of the 2007 playbook. Bet the whole fund on a short in a single stock. Have these guys not heard of diversification?
Btw here is a link to the 2007 playbook. It’s one of these timeless articles, just as relevant today.
Why am I writing this
Because my phone got flooded with notifications about GME and the headlines were the kind of thing no one needs. Here’s why I don’t read financial news:
It’s a mixed bag, some think institutions manipulated the market, others think Reddit users did. The important part is that everyone has an opinion, usually the us against them type and thin on substance.
Do we need so much animosity and polarity? No we don’t. What we need is a level-headed analysis of the events with propositions for further action.
Some called for WallStreetBets (WSB) to be shut down. I am against that because it’s a violation of free speech. Why should I be unable to share my favourite tickers with others?
You shut down WSB and everyone will go to Twitter, Facebook, Snapchat or elsewhere, it’s a pointless waste of effort.
Why did the GME case create so much noise
The market is supposed to be fair and so on. All of the news outlets lead you to believe that you can do your research, trust analyst recommendations, buy shares in good companies and get rich.
Unfortunately this has never been true for a few reasons. First, no one knows what the market is going to do next. That’s just the way the world works. Ask any physicist ‘Can I predict the future‘ and the answer will likely be close enough to a ‘No’.
I understand that someone may beg to differ and if so please explain why no one managed to prevent the last 3 stock market crashes.
We’re told to pay the professionals to do the job even though this never worked. People are getting fed up, often based on sound reasoning.
The moral of the story
These are all smart people who spend days, weeks and months producing analysis, building portfolios, etc. I don’t think there’s any malice involved. It’s the uncertainty effect.
Who could have predicted the Covid-19 pandemic?
Would you share a high return strategy
Think about it, if I knew how to make outsized returns why would I share this with anyone? Let’s say I know how to make 10x every year with almost zero risk. My 5 year P&L would look like this:
That’s 161 million, 6 years bring it to the 9 zero club. I won’t start with 1k though, I’ll borrow all the money I can, sell my house and go all in. The last thing on my mind would be to start a fund or write analyst articles.
The same theme can be found in the management literature because the world is chaotic and random. You throw a pair of dice, metaphorically speaking, every time you walk out the door and it works out about the same when it comes to company performance or share price.
Ask an economist
I remember talking with my Economics professor about competitive strategy and the ability of management to influence performance outcomes.
All he said was that about 97% of occurrences in competitive strategy are random and management skill can deliver in the remaining 3%. Then he continued with ‘if I knew a sure way to become a millionaire I wouldn’t be teaching you lot’.
The share price is supposed to be based on future company performance so let this thought sink in a bit.
What’s the purpose of financial media articles then
They are pretty valuable if you ask me, I can check out other people’s opinions on a company, hear different points of view, etc.
A friend of mine recently started investing and lost a small bit of money to a market order. He didn’t know what a limit order is. Unthinkable, right?
Not really, we all start somewhere and it’s always good to to read something to inform your trading.
Recommendations and articles can become a problem when people follow them without any research of their own.
Institutions are used to a significant edge over the individual investor and that’s understandable.
Funds trade stock and options all the time in large volume. Let’s say you acquired the knowledge to remove a kidney stone. Can you do it without access to hospital facilities?
A hedge fund would never in a million years envision getting smoked by a Reddit group. So some professionals claimed WSB manipulated the market as per the articles above.
The market can be a zero sum game and it’s one of these expect the unexpected places. It’s one thing I love about it, there’s something new every day.
It may be more constructive to look into the fund’s risk strategy or lack thereof and then draw conclusions about the events.
You can’t trade like an institution
Which brings us to the next point. Have you ever heard ‘trade like an institution‘?
Some articles and YouTube videos may lead you to believe that there are thousands of people at investment banks waiting for MACD, VWAP or the RSI (technical indicators) to cross some line before they start clicking frantically the buy and sell buttons on their terminals.
They use technical analysis but it’s not the one and only tool. And if it was, why are you sat in front of a screen, start coding and write a trading algorithm.
Institutions use this, institutions use that. It doesn’t matter, if you’re retail you need your own tools and your own mechanics.
I once talked to an investment banker who went to see her buddy, head of the Oil division. Guess what was on the computer screen. Tankers, thousands and thousands of tankers blinking on the screen.
The takeaway is that the banker has a team of analysts, quants, risk managers and so on who go through huge amounts of information. It’s a coordinated effort.
That’s because the volume of data exceeds the cognitive capacity of a single human brain. I’m on my own, I can’t trade like them and that’s ok.
Don’t take my word for it, listen to the Alpha Trader podcast
I only listened to the first 10 minutes of the Alpha Trader podcast because it seemed to create an additional layer of polarity. That’s not usually the case, but like I said GME is somewhat special that way.
In summary, the Alpha Trader is used to buy stuff before it’s available to the general public and then makes 100x on his money.
Then he talked about how investment banks overhype stocks prior to an initial public offering (IPO). They bought the shares dirt cheap a year before the IPO. Analysts wrote a whole bunch of buy recommendations and the bank then sold them at an inflated price.
That’s not a secret, I already wrote about this here. He made a good point when he said that retail market access is one area which can be improved upon. Agreed!!
I don’t like animosity whether you’re retail or an institution
I stopped listening after the Alpha Trader said how Melvin Capital got attacked by a bee hive of frenzied retail traders.
Then he went on to compare them to an armed mob and criticized politicians for attempting to preserve a level playing field.
These are the kind of statements which no one needs. Let’s be more constructive.
I believe that we should never forget history because it tends to repeat itself over and over again.
The case of Soros vs The Bank of England (1992) is a good example of the few against a central bank. Who would have expected that a handful of speculators can decimate a G7 economy’s central bank?
But they did because believe it or not their research was better. Sometimes you can’t maintain a currency peg.
The takeaway is that the Market doesn’t care who you are. You may be a retail investor, a hedge fund or a central bank, you can blow up your account just the same.
I am on the Market’s side on this one, it’s fair.
What do other professionals have to say
I once talked to a former broker who said he hated the job. He explained that the brokerage used to get cheap shares and then sell them at inflated prices by soliciting clients who were calling over the phone to ask what’s the next big thing.
Who calls the broker to ask for advice and buy shares over the phone? These people are the ones who will benefit greatly from professional advice. I already discussed this here.
If you wonder what it’s like to be a market maker, check out JJ, a former pro turned retail. He’s got some interesting stuff to say:
Still, don’t take his word for it. Just listen and then watch the price action of your favourite stocks to see if this is true or not. You can also read The Economist’s Shark Attack from the 6th of Feb 2021 issue. Sorry I couldn’t find a link.
Is market making bad?
Citadel Securities doubled their profits last year because of the increased retail activity. They buy order flow from Robinhood so this just goes to show that a lot of retail investors show up to a gunfight with a violin.
Citadel know what you ordered and the price you are willing to pay prior to market open. JJ explains that quite well in the podcast above. Nothing is ever free, the money needs to come from somewhere one way or the other.
But sometimes it’s a good thing. I agree with JJ that there would be no market without the market makers.
If you need proof look no further than the European options market. There isn’t one! I wouldn’t be surprised if the total open interest of UK stock options is less than a single strike in SPY.
This is partly because anyone with a pulse can open a CFD account in 2 minutes or less.
It’s the fees
There are only two certain things in life and one of them is that you will pay fees in one form or another. It doesn’t matter whether it’s maintenance fees, transaction fees or a bid-ask spread, you’ll be paying something.
Goldman absolutely crushed it last year, note the discrepancy between analyst estimates and actuals, but not because of tracking a candle piercing through VWAP. It was because of the increased trading volume and their asset management division a.k.a. the fees.
You can’t invest like Warren Buffett
The other revenue stream of institutions is what the Alpha Trader was talking about, the access. Find some cheap shares, overhype them, make 100x. There’s a reason why an investment bank is called a sell-side institution.
An investment banker once told me that Buffett was offered shares of some company for $100 per share. He didn’t want them so the bank told him the offer is on the table forever, no matter where the price goes.
I understand that, I’d want a shareholder like Buffett if I was a CEO.
Buffett trades options too, in large volume, so you can’t replicate him in your ISA. You may have read something else in a book somewhere. I’m sorry but you were lied to.
He’s amazing, I want to be like him or Charlie Munger too but I know I can’t.
It’s because most trading education is obsolete
A lot of people spend day after day reading book after book and I can’t understand why.
You have to start somewhere and a book is a great way to learn the basics. Then you move on because books are obsolete prior to publishing.
The Market is a dynamic, forward looking place and also the best educational resource. Yes, history repeats itself but not in the exact same way, it’s not a carbon copy.
What happened with GME
Basically, some people at WSB, thought that the stock was under-priced and started buying it a few moths ago.
I have to point out that there are some heavy hitters there, in retail terms. If you skip the noise you’ll find good research and screenshots of accounts worth millions.
I’m a member of WSB and I assure you it’s not a joke if you look at the right threads/comments.
I get it, I used to play video games so I’d be inclined to buy shares of my childhood toys retailer too. That’s not because of clever math or ‘sound fundamentals’, whatever this means these days.
I’d buy the memory and the emotion. It has been proven beyond doubt that we’re not always rational and that’s ok, we don’t have to be.
When I was a teenager I loved Nvidia products but I couldn’t buy shares. Now I can but it’s too expensive for me.
What if it drops to $5 per share? Of course I’ll buy the memory and I won’t really care if I lose some money on it. There are things that don’t have a price tag attached.
I can’t speak for everyone‘s reasoning to purchase GME but I get it and I understand why someone may not care as much about the fundamentals. Here’s the share price chart between 1 Jan 2010 and 1 Jan 2021:
There isn’t anything unreasonable about buying it for $5. It’s a lose up to $500 or make $2-3k kind of trade.
Worst case scenario, it will linger on at $2-3 for a while before it goes bust so the max loss would be more like $200-300 per board lot. There may have been some cheap options for the more risk averse.
It doesn’t seem like a bad trade to me, the risk reward ratio is great. And then have a look at the fundamentals. I don’t think this stock should ever trade below $10, more like $15-20 as a minimum. They got a new investor on board who’s looking into bringing the company to the digital economy.
Even if that fails it’s still a very decent takeover target at a market cap of $350 million. There’s always a deep pocket private equity fund looking for companies like that. Look at what happened with Rosetta Stone, the share price doubled before the buyout.
What did hedge funds have to say?
Apparently it was overvalued at $25-30 and hedge funds thought they’ll make a quick buck by short selling the stock:
However, it’s not the fundamentals or personal opinions that decide how much a stock is worth. The Market decides what’s the price of a share at a given moment in time.
So if the Market says that it’s worth $25 then it’s worth $25. Don’t mistake the Market for Benjamin Graham’s Mr Market. The latter is more of behavioural economics thing while the Market is just the stock market.
What is short selling
You short sell shares when you borrow them from your friends and then sell them. However, at some point they will want their shares back so you have to buy them on the open market and return them.
Implicitly, you need to sell them for a high price and then buy low. The only difference compared to ‘buy now sell later’ is that the sequence of the transactions is reversed and you need to pay your friends some interest.
We can present this mathematically in the following way:
Buy shares: buy 10 shares x $10 = -$100 then sell them for $15 x 10 = +$150 equals a profit of $50
Short sell shares: borrow and sell 10 shares x $15 = +$150 then buy them back for $10 x 10 = -$100 equals a profit of $50
You can see that there’s not much difference. Have you ever thought something like ‘omg, these shares are so expensive, I wish I had some to sell because I’m sure they’re going to crash’? You were thinking like a short seller.
Is shorting bad?
I can’t really answer with a generalised yes or no but it’s definitely controversial.
There are comments on social media such as ‘I closed my brokerage account because they lend my shares to short sellers and this is immoral’.
Even Elon Musk said you can’t short sell a house. That’s not exactly true because you’re still short mortgage backed securities. You made a bet that the money the bank lent you will be worth less than the house in the future.
Mechanically it’s exactly the same as shorting shares, you borrow something (money), you sell it (buy a house), you cover later (pay mortgage). Otherwise, why would anyone be worried about negative equity?
So he’s partially right you’re long on the house but you’re short on the loan.
But what if there is an abundance of houses, dirt cheap rents and the house value drops by 10% per year. You borrow the house and pay interest in the form of rent, then you wait and buy when it’s cheap.
You’re long cash and short the housing market. You expect to make money from the difference between the rent and the house value.
Numerical Example of ‘house shorting’ considering 10% loss of value per year and availability of funds to purchase it:
The good part
The good part is that short sellers do more research because the loss from a short is theoretically unlimited. Sometimes, they expose companies which have issues.
Another positive thing is that they stabilise the share price when the market is crashing. Imagine that you wake up to an S&P 500 market wide circuit breaker and the VIX is up to 70. Do you start buying shares immediately after the halt ends?
I didn’t think so but that’s when short sellers start covering their positions. New bids enter the market and the price starts to stabilise. You lose less money thanks to the shorts.
And then they boost your retirement pot too! Pension funds often lend shares to speculators and make a buck from the interest.
The bad part
The bad part is that shorting can depress the share price. Have you heard of a short selling attack? That’s when you short a large volume of shares all of a sudden, like 10% of the free float or in the case of GME 150%.
Inevitably, the price goes down based on the large volume of sell orders. Do you think I’d be happy with that if I had shares in the company? That’s the issue of the retail traders in the GME case.
Naked short selling
How can you short 150% of the shares? This is a very good question, perhaps SEC Enforcement should answer this. It’s called naked short selling and is currently illegal.
You sell the shares without proof that they actually existed. Try doing that as a retail investor. Here is a nice article which takes no prisoners.
Who’s going to jail over this? My bet is no one. Now you begin to understand where the anger is coming from.
Some market participants seem to be able to break the law with impunity.
What is a short Gamma squeeze and a short squeeze
GME’s parabolic move started as a short Gamma squeeze. This happens whenever traders buy large amounts of call options, especially in an illiquid stock.
The mechanics of a short Gamma squeeze
Options market makers, such as Citadel Securities and Virtu, are usually Delta hedged and try to maintain Delta neutrality (to a point) in order to collect the bid ask spread and to make some money from time and volatility.
Whenever you buy a call option the market maker may buy a number of shares corresponding to the Delta depending on the available inventory of options.
Puts and calls neutralise each other, for example if you buy or sell a Strangle or a Straddle you’re Delta neutral by design. However, sometimes the call or the put side may dominate the market and you may need to use shares.
Delta hedging and reverse Gamma scalping
The contracts which are at the money usually have around 50 Delta which results in the purchase of 50 shares. That’s Delta hedging.
100k contracts lead to the purchase of 5 million shares. However, the share price moves and it will go up if someone starts to buy large batches.
Each option has Gamma so if the 50 Delta option has a Gamma of 5, the market maker will need to buy 5 additional shares for each $1 increase of the share price. This is called reverse Gamma scalping.
Therefore, if GME goes up by $5 the market maker will need to buy another 2.5 million shares per 100k contracts to remain Delta neutral which inflates the price further. This can happen quite quickly and you will observe a parabolic up-move on a share price chart.
At some point the price of the options becomes unreasonable and traders can’t pump it up via the market maker anymore.
Here is the volume and open interest of GME options with expiration of 3 weeks or more at the close on the 29th of January. You can see that the call option volume dries up beyond the $60 strike:
Options are not feasible anymore so traders switched to shares.
The short squeeze
A squeeze forces short sellers to cover their positions at a loss. They sold the shares for $60 but now the price is $90 so they are out of pocket $30 per share. They start sending bids to cover at any price and the shares go to the moon.
The retail side helped by buying more and more shares, all of them, until the price went up to $350, even $480 intra-day!
There was a scene from the 300 movie on WSB. King Leonidas was told ‘This is madness’ and he just shouted ‘This is Sparta’. Only this time it said ‘This is WallStreetBets!’.
They forced some short sellers to close at a price between $100 – $300 per share.
Why did retail traders become so angry
You may be thinking ‘some people are long stock, some are short stock so what is the deal with GME, why is it different’. It’s not, early investors spotted the short squeeze opportunity and made a lot of money.
Then GME gained traction via the media polarity, some investors on the retail side thought the Market is unfair and decided to make a political statement and fry a hedge fund or two.
I feel for these guys because a lot of them bought the stock for $300 only to find out that the Market can be blind to politics. I saw comments like ‘make sure you are on the right side of history’.
Here’s the history of the short interest in SPY which shows that short selling is fairly common, there are at least 5m shares short at any one time:
In fact half of my watchlist was hard to borrow the last week of January. This means that a lot of people were shorting stock and they pay interest to borrow shares, sometimes 200% per year or more!
It became personal
Part of the problem is that we are being told how we are incompetent, financially illiterate, inexperienced and all sorts of other things by finance professionals all the time. Remember the Alpha Trader who called us a frenzied mob.
At the same time active management has no results to convince anyone of the presence of skill.
It’s also one of the issues in relation to the impersonality of the internet. Sometimes people say things and don’t realise how much they affect the other side.
Next time you decide to make a hateful comment on the internet pause for a moment and watch Jesy Nelson’s story, a former member of Little Mix, a music band.
I want a Market which is a happy place where everyone can make money! No insults, no polarity, just all of us getting richer one trade at a time.
That’s why I love options. I can buy a call which is sold to me by the Market Maker. They can neutralise the directional exposure of the call to prevent losing money no matter how much I make.
So I make money and the Market maker makes money, that’s the kind of positive sum game I want to participate in.
It turned into us against them
But it’s not just the words, it’s something called inequity. Too big to fail is a major part of this. Remember when banks trashed the whole economy with the 2007 playbook I posted above? Who got punished for that?
One banker got jailed in the US and zero in the UK. The US one looks a bit like ‘the fall guy‘, he wasn’t even middle management.
I feel for you buddy, I’ve been there too, you’re not alone
That’s what one Redditor thought too, his family suffered hardship during the financial crisis 2007-2009.
I know where he’s coming from, my parents struggled to put food on the table too only that is was a few years after the fall of the Berlin Wall in 1989.
Once we went to the woods to pick wild mushrooms. And then I saw my grandmother crying when we couldn’t afford a loaf of bread during the first hyperinflation cycle.
I’ve had people look down on me, insult me and so on just because I was poor. It’s not great but at the end of the day people are people. My dad used to tell me that you play the hand you are dealt not the one you wish you had.
We all want to have someone to blame but truth be told I always thought that we were just unlucky. Maybe because my dad used to tell me that Fortuna will come to our house one day.
Anyway, that’s a story for another day. Case in point, I understand the guy. If any of you lot have that much hatred, please email me at email@example.com. I’ll do my best to help you out, the door’s always open.
Should there be a too big to fail
The multi billion bank bailout in the UK and the US was at the taxpayer’s expense and there are no results to show for it.
But what’s the alternative? Creative destruction.
We all thought that the world was going to end when the Soviet Union crashed, but guess what, we got to live another day, new institutions emerged and things improved over time.
It was hard, I can’t deny that. But what’s the alternative, to keep pouring money in a failing system.
It’s a bit like price cost averaging when the share price is going down. You bought shares for $100 and they dropped to $50, you buy more. But do you buy more if the price goes down to $1.
You can average down the price to just over $1 if you have an infinite amount of money and you’ll still lose unless the price bounces back.
Revenge is best served cold
I was watching Star Trek and there was a scene where Mr Spock travelled back in time to talk to Captain Kirk about an adversary of theirs. Kirk asked if they will manage to beat their enemy and Spock replied ‘Yes, but at great cost’.
The similarity is that traders bought GME and then found out that funds were shorting the stock. They knew that this will drive the price down especially at 150% short interest.
Based on official data hedge funds shorted 30 million shares. FINRA doesn’t seem to record the non-existing ones, maybe because it’s illegal. Even so that’s 64% of the free float!
The free float consists of all the shares which are available for purchase in the open market. There is restricted stock owned by management and other parties which is subject to separate regulations.
There was no way the price will remain stable with that many sell orders. However, now we have social media and when the retail side found out they just declared war on the funds.
It’s not a joke, GME is what war looks like in the stock market. Some of the funds were smart enough to close their positions in mid January.
However, there is always someone who wants to make a buck so the shorting was back on when GME hit the $50-60 price level.
Social media is an asset
You’ve bought your GME shares in the hope that you’ll make some money on your childhood memories only to find out that a hedge fund is trying to bankrupt the company. What do you do next?
I’d go on social media and start moaning about it. That’s what it is for. It turned out that many retail investors and traders were affected.
At some point someone came up with the idea to pump up the price of GME to infinity starting with the short Gamma squeeze and then a short squeeze. This is what I call a stroke of a genius! And the result was nothing less than astonishing:
Millions of people started buying shares until they pumped up the price to $350. Not only that but they maintained it for a week. Except for the 28th of January when brokers suspended trading.
This is part of something bigger
Some described the GME squeeze as Occupy Wall Street 2.0, a political cause, rob the bankers, you name it.
It’s just a symptom of broader macroeconomic events which have been taking place for decades. I already talked about financialization.
The productive economy doesn’t work anymore
It’s the increasing importance of capital over labour, decrease in real earnings and ballooning of the value of paper assets (houses, shares, etc.).
Go on Facebook and read the comments under a random article by Bloomberg, the FT or the Economist. There is so much anger and polarity, most of which is about the inequality in the income distribution.
This thing has been going on for hundreds of years, check out the Pareto distribution. However, the world is connected nowadays and the super rich are more visible.
People go to work all day and there are no results, while someone else makes like 5 billion in a day from stock or gets a 100 million bonus.
There is a term in the management literature called pay for failure. This is when the management team of a company pays themselves a bonus prior to bankruptcy. They got paid for what exactly?
I gave up on the productive economy and started trading. Call me mad but it seems to be feasible only for people with deep pockets and risk takers.
If capital is the determining force of success then you stand on the side of capital, simple.
Is everyone getting poorer
There are a few aspects to this, the first one is where exactly. People in developing countries are actually getting richer, that is if you count something like an income of $15k as being rich.
The IMF stats show that the number of people living on less than $2 per day has decreased dramatically.
However, half of the globe still lives on less than $5.50 per day which adds up to $8,000 per household of 2 adults and 2 children per year.
Are developed countries getting poorer
People feel that the economic state of affairs doesn’t work for them and that they are getting poorer. No one in the US or the UK thinks ‘oh well, there are all these people somewhere that live on $5 so I’m doing well’.
We also have to take living expenses into account.
I’ve often seen headlines such as ‘poorer than their parents’ which brings us to an important point about evolution and progress.
Time is not linear
A linear perception of time. I am a member of a few investing groups and I couldn’t help but notice that a lot of new investors think of shares as a vehicle with a linear return, a sure thing.
The only question being asked is ‘how much money am I going to make’. No one asks what’s the risk or how not to blow up a trading account.
Have you heard the following ‘I bought XYZ and I expect to compound an annual 10% for 30 years and retire well’. What if the market crashes or the company goes bust, if there is a war or a Berlin Wall 2.0 event in the developed world?
No one can make an accurate 30 year forecast.
None other but Einstein himself said that time can run quicker or slower, similar to the quote by Lenin in the beginning of the article. So it is normal for a country to go through a period of decline, it’s not impossible for someone to be poorer than their parents.
The rise of identity politics
Current events are troubling to a degree. I never thought that something as simple as wearing a mask or a purchase of stock can turn into a political statement.
And this is dangerous, the polarity in the world is increasing to a point where blame is attached to everything. People are getting angry and we see a rise of the ‘us against them’ line of reasoning.
Social media can make things worse by reinforcing something called the firehouse syndrome. You hold an extreme view, like the world is flat for example, you go on Facebook and you find a group of fellow flat-earthers which just reinforces the extreme view. Facts don’t matter anymore.
Check all sides of an argument
Vladimir Putin spoke at the WEF not long ago, think of him what you wish but he’s smart and has top quality research straight from the FSB so I’m listening:
I posted Putin because I want to have a look at this from different angles.
In summary he thinks that the geopolitical situation is becoming unstable and some of the events prior to World War II are being repeated. Then he called for global cooperation to prevent a future decline of world affairs.
The most troubling thing was the potential for a severe decline in world development even though the GDP measured by PPP has doubled since 1980. His words resonate with the data showing that developing countries gained a lot over the past half a century.
I agree that all of us need to do whatever we can to preserve progress.
Now back to the GME case.
Brokers just made things worse
We already have millions who are dissatisfied with the economic conjuncture and think the Market is unfair. Brokers only added insult to injury by restricting trading in GME.
Most of the noise in the media pointed towards retail only denial of service but I think the hedge funds got affected too, although they retained access to ‘dark pools’.
There is also some data pointing towards a prevalence of institutional activity in the GME price action.
No one knows what is legitimate information these days but it adds up as most transactions are institutional.
The Interactive Brokers’ point of view
IBKR is a large US firm which is an intermediary to smaller companies like Trading 212 here in the UK but they also serve retail customers.
I was checking out the news the other day and I came across an interview with the Chairman of Interactive Brokers. I’m not sure if he meant to be patronising and arrogant but he succeeded at both:
This kind of language only makes things worse. I don’t think that he explained the situation well so I took it upon myself to go over each of his statements.
In summary, he said that IBKR were protecting themselves and their customers. However, he did not specify which customers, institutional or retail ones, maybe he meant both, I don’t know. Then he talked about counterparty risk and the clearing system.
The latter two are obscure to a lot of retail investors so I’ll try to explain this in more detail.
I have an issue with IBKR’s actions because I don’t feel that a broker should be the one who decides what a company trades for. That’s the Market’s job.
I’m happy for them to halt trading as long as they are prepared to cover any losses whether realised or in terms of opportunity.
For example, I buy a share for $20, the price goes up to $350 but I can’t sell it because IBKR suspended trading. Then it goes down to $50. I think that IBKR should come up with the $300 I missed out on, it’s only fair.
Food for thought for the regulators.
The counterparty risk
There were no call options beyond the $60 strike as you already saw in the screenshot in the Gamma squeeze section. Let’s compare GME with SPY:
Notice the difference? I thought so. Below are the interactive charts which show the exact volume and open interest for each strike with an open interest above 500 and expiry over 3 weeks:
I have to point out that open interest by itself doesn’t mean that much. Mainly because it doesn’t reveal the motivation of the market participants.
We’re only looking at the open interest in terms of counterparty risk.
I think we have to dig a bit deeper still. Here is the total options activity per day courtesy of the CBOE:
Did you notice that the overall options activity does indeed increase but not as dramatically as you would think based on the video. However, this happened on the 27th of January, a day before the Chairman’s arbitrary trading halt.
There was a 70% spike in the VIX that day, more on that later. This is the kind of thing that can account for the increased options activity on the 27th of January.
It makes sense because options started off as a hedging tool. Therefore, it seems logical that investors will buy options to protect themselves when fear goes through the roof. However, there may be other reasons.
Interactive Brokers were worried they may have to foot the bill
It’s happened to them before when their software failed to reflect that commodity futures can go negative and lost just over $100m.
This may not have happened before but everyone knows that physical commodity futures can turn negative.
Traders speculate on the price of oil, corn, coffee or something and eventually they end up trapped in the contract and have to take physical delivery or supply the goods. But you can’t store oil in your garden or come up with it so you’d pay money to get rid of the contract.
You’d notice a similar theme at Robinhood, an undercapitalised US broker. Apparently, they didn’t have enough money to satisfy SEC requirements. Why is that company in business, where are the regulators when we need them?
Both of these firms talked a lot about margin requirements. I feel it’s necessary to look into this.
The margin requirements
These apply if you trade in a margin account. Such an account is required if you want to trade options, futures or short sell stock.
You don’t use margin in a cash account or an ISA. HL don’t offer margin accounts and they carried on filling orders and so did other brokers.
How does trading on margin work?
It works in the following way: you buy stock and you put up 50%, you short sell stock and you put up 150% of the trade value. There is a formula if you sell options but it’s usually something like 20% of the notional value for a 20 Delta contract. All the details can be found on FINRA’s website.
The caveat is that it fluctuates, it’s a dynamic margin, so if you are short stock and the price goes up the broker will block more of your money.
You may have heard of a margin call, there was a movie about it, albeit not the best finance production. The best finance movie I’ve watched was The Big Short. It’s a great place to start if you want to understand how this whole house of cards works.
I’m sorry I digressed, back to the margin requirements. I think we need a numerical example.
Margin for long stock
Imagine that I bought 100 shares of GME for $10 each, I’ve got $10k in my account and I have no other positions.
100 x $10 = $1000
I put up $500 and I borrow $500 of the Chairman’s money. He charges a handsome interest of 8% per year, which is btw more than the average stock market return of 6-7% as advertised by professionals. You may remember I was talking about fees earlier.
GME goes up to $20, I just made 1k on $500 of my own money
Gross profit $2,000 – Margin $500 = $1,500
Net profit = 1,500 – 500 = $1,000 which adds up to 200% instead of 100% because I used margin.
You may think, well that’s alright sounds like a cash account. It turns into a problem when I decide to buy 2k shares and block all of the money in my account.
Then if the price drops to say $3 my balance will be negative:
2,000 shares x $10 = $20,000
2,000 shares x $3 = $6,000
The net result is -$14,000, however, I only had $10k in the account so now Interactive Brokers need to find me to retrieve the remaining $4k. It works in a similar way for short sales and options.
The margin call
The Chairman seems busy to theorise what the value of GME may be so he wouldn’t want to spend time travelling only to find out that I have hidden in the nearby woods.
That’s why the margin is dynamic, it goes up as the share price goes down. I’ll be getting an email or a phone call long before I’m on the hook for an extra $4k and my position will be liquidated if I don’t come up with additional capital.
It’s a bit different for options. You only need to put up margin if you have sold options. It goes up if the stock goes against you and it goes down when it moves in your favour.
Any half decent broker will send you an email like the one on the right to make sure you are prepared to meet your obligations.
Who can open a margin account and is this whole thing a problem
I know that this raises some questions, like why is the Chairman lending money to everyone with a pulse? There must be some kind of approval process?
This is not a question that I can answer. Let’s just say that brokers are happy to lend you money and charge you fees as long as they don’t end up on the losing side. It’s perfectly fine if you lose money though. Be careful out there!
Interactive Brokers can lose money on a highly volatile stock because the price moves too quickly to adjust any positions which are turning sour. They don’t want to take field trips to look for their customers.
Example of an institutional margin call
Here’s a funny story. I had a brilliant idea a few years ago, to open a small clearing house. So I talked to a banker who’s worked at one. He told me to forget about it but then we started chit chatting about how it works so listen to this.
Back in the 2000s someone called the clearing house to execute a 100 million margin call. Whoever picked up the phone was new and since that’s a small transaction they just said ok and carried on with their day.
The next thing you know the CEO was on the floor shouting. It turned out that a 2.5 billion position (prior to the deleveraging of banks) was turning sour and no one knew where this thing came from. So there was a remote possibility that some institution somewhere was getting smoked, badly.
Since everything is connected they were worried of a domino effect. It’s similar to the 2007-2009 financial crisis when everyone knew there were rotten tranches of mortgage backed securities but neither party could identify them so each bank was waiting for the others to burn down.
That’s the kind of thing the Chairman is worried about.
Who was getting hurt by the volatility
GME’s volatility was already over 500% at the time when the Chairman shut down trading. Presumably IBKR should have increased the margin requirements as the stock volatility was expanding, like 2 months ago.
I trade options on margin and it increases whenever volatility increases. It’s a fairly standard thing.
The margin requirement for short options can be 100% on the put side which tells me the clearing house thinks that the price can go to 0. I don’t sell options in stock like that because I think these guys know what they’re talking about.
We could say that the Chairman didn’t want a whole bunch of people to trade GME on margin at $350 per share. Then why didn’t they just increase the margin to 100% and restrict short selling, problem solved?
Actually short selling was made less lucrative by the 80% interest you had to pay to borrow the shares.
I just keep coming up with more questions the more I look into this.
One of the problems I see in the Chairman’s statement is that the retail traders were on the buy side. A lot of retail investors in the UK don’t even know what a margin account is let alone how to short sell shares.
And then options are like something that comes straight out of science fiction. You don’t believe me, read this.
Most of the short interest was on the hedge funds’ side so there’s one party IBKR were worried about.
What’s the implication for options traders
If you trade options you know that sometimes you buy them, sometimes you sell them, sometimes you mix things up a bit. Either way one thing is certain, no retail options trader will ever sell call options in a stock like GME.
Again, don’t take my word for it. Find a highly volatile stock then go to Reddit’s r/Options and post the following ‘I want to sell a whole bunch of naked calls in XYZ’. See what kind of feedback you’ll get.
Market making firms are the ones who sell these call options. They have the resources to do it in a safe manner as explained above, well most of the time anyway.
Here’s how it works, assuming GME is trading for $40 and the volatility is 200%:
Sell 1x 40 day $70 strike call in GME for $3.76, collect $376 per contract.
10 days later GME goes up to $350, volatility goes up to 500% and the call’s price is now $292. You’re down $288.24 per option which adds up to $28,824 per contract.
Let’s imagine that the initial margin requirement was 100% of the notional value, $7,000. It would have been a lot less, likely in the 3 figure or low 4 figure range, but this is just for illustrative purposes so we’ll stick to $7k.
Your have $100,000 in your account and you decide to sell 5 contracts. IBKR blocks $35k – (5 x $376) ~ $33k. You’re left with $67k to trade other stuff.
10 days later your account value is $100,000 – ( 5 x $28,824 ) = -$44,120.
Whoever bought these from you is up $144,120 on a $1,880 investment.
Now you understand why I would drop dead before I sell call options in a stock like GME. Buying them on the other hand is the kind of trade the Alpha Trader was talking about.
Only that IBKR restricted options trading to liquidation only.
This means that no one will buy your options. You’ll need to exercise them which will take a few days and you’ll lose a lot of your gains as it was clear that the $350 price level is unsustainable.
So whoever sold you the options just needs the trading ban to last long enough for GME’s share price to go back below $70 prior to expiration to pick up your $376 and walk away scot free.
Imagine what would happen if a market maker sold 10,000 of the contracts in the numerical example and had to cover at $350. We’re looking at a loss of ~$290 million.
It’s not the same as Melvin Capital’s P&L but it’s a lot to lose over 10k options contracts.
So which clients were protected by the Chairman’s actions? Where is SEC Enforcement?
It would be up to the regulators to find out if IBKR favoured some of their clients at the expense of others. Should that be the case it would be reasonable to force a carve out of any division which produces conflicts of interest.
It’s not just that. Here’s the real problem!
The Chairman failed to mention something called DTCC, a 3rd party which clears margin account transactions. There is a window of time when IBKR have to come up with cash. You can read a detailed explanation of the mechanics of this at Zero Hedge.
In short, there was only one side to the GME trade which was causing the headache. The short sellers and call option sellers on the way up and then the stock buyers and put option sellers on the way down.
Remember when I said how I’d drop dead before I sell you a call? The same goes for selling a put.
So IBKR have a massive notional exposure on both ends of this trade with no one willing to take the other side. It’s a bit like sitting on a crate with dynamite and throwing matches next to it.
I was looking at the GME options but I wanted to buy them, either a put or a butterfly. Guess what, no one wanted to sell any, at least not for a reasonable price.
Strain on the clearing system?
Besides the liquidity issue above, the only other way this can cause a strain on the clearing system is if there is a heavily leveraged institution involved.
I wonder if the FED offers better margin rates than IBKR and if they accept retail customers. Remember how you get 1:1 margin from IBKR, these guys get 1:10.
Let’s say you have a 10bn fund and you’re short 5 million shares in GME at a price of $20. That’s 100 million, 1% of the fund value.
Then the stock goes up to $300, you’re looking at a P&L of -1.4 billion. What if you only had 1 billion and levered the rest? You’ll have -400 million in cash.
Last year the S&P 500 lost around 30% of its value, ~$15 trillion, the options market was bonkers and the clearing system survived.
It’s happened before
Check out Long Term Capital Management’s story in the Smart Money Failures section to find out how even a Dream Team can wipe out billions.
All bailed out with tax payer money. It may be a cliché but there’s a reason why the definition of insanity is to do the same thing over and over again and expect a different outcome. Especially when it involves pouring a large amount of government money in private institutions.
This is why I support the creative destruction approach, let them fail and see what kind of phoenix will emerge from the ashes. It could be something better.
It caused a 70% spike in the VIX
The value of the VIX is derived from the at-the-money options in the S&P 500 and GME is not a constituent.
However, we have brokers, market makers and hedge funds in a situation where the liquidity is drying up rapidly and it’s just a matter of time before someone loses their shirt.
It seems we never learn from history.
In conclusion the Market created some winners and losers. There was no market warfare or at least not until brokers started shutting down trading.
However, there were 3 major issues: naked short selling, a liquidity problem and leverage.
The Economist published a well-balanced, albeit short, article called ‘Shark Attack’ (no link available, 6th of Feb 2021 issue). It describes the Market as a survival of the fittest type jungle where wounded animals serve as prey.
You can find the same theme in any macroeconomics textbook. It may not be the way we all want the Market to function but it is what it is.
Implications for retail traders
Overall, this fiasco rattled everyone’s confidence in the Market, especially regarding the reliability of brokers. It is difficult to invest in a speculative stock when you don’t know if or when you’d be able to get out of the position.
I have to admit, with great regret, that all the events point that retail investors are at a disadvantage in the Market and are subject to arbitrary actions by private companies.
I would like to see either creative destruction or new regulation aimed to provide a level playing field. It would be great if someone actually gets caught for the naked short selling.
Sadly, I don’t believe this would ever happen unless the current financialized conjuncture blows up in a spectacular fashion. Unfortunately, this is likely to bring some major macroeconomic event we’ll all suffer from, like Berlin Wall 2.0.
If you have any information of any wrongdoing please send it to AOC, Ted Cruz and SEC Enforcement. The first two seemed to be interested in this. I don’t follow US politics in detail so I can’t comment on their reliability or motivation.