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The Quiet Storm

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Short-sellers burned as small investors pile into Gamestop options

Written by on 27/01/2021

Even in a market environment that many seasoned participants are describing as a bubble, the meteoric rise of shares in Gamestop has been something else.

Shares of the US computer game retailer had, by the close on Tuesday night, rocketed by 685% since the beginning of the year – propelling the stock market value of the business beyond $10bn.

The reason for this stunning rise is only partly to do with a sudden reappraisal of the company’s prospects.

Traders work on the floor of the NYSE in New York 19/11/18
Image: US stock markets have seen a shift in the balance of power

It mainly reflects what is being seen in some quarters as a shifting of the balance of power in US stock markets.

The last year or so has seen a revolution in US stock trading with millions of Americans taking up the practice for the first time, empowered by zero-commission platforms such as Robinhood and Tastytrade, the platform bought last week by the British company IG Group.

These investors have taken to discussing stock trading ideas on websites such as Reddit and on private Facebook groups such as ‘Robin Hood’s Stock Market Watchlist’.

In the process, they have taken to developing interesting trading strategies, some of which until now have only been the preserve of sophisticated investors.

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One of these is using stock options.

A ‘call’ option gives the buyer the right – but not the obligation – to buy a security, such as a share or a bond, at a specified price on a specified date.

Robinhood to pay $65 million to settle Security and Exchange Commissioin (SEC) charges. STAR MAX File Photo: 12/17/20
Image: Small-time investors have been empowered by platforms such as Robinhood

A ‘put’ option, similarly, gives the buyer the right – but not the obligation – to sell a security at a specified price and on a specified date.

For investors, it is a good way of leveraging your position, since with an option the investor is only staking a fraction of the value of the underlying instrument.

It is, of course, more risky.

What appears to have happened with Gamestop is that a number of these private investors have taken to buying call options in Gamestop – in other words betting on a rise in the share price.

When a broker sells an investor a ‘call’ option, they will seek to ‘hedge’ their risk, for example by buying shares in that company themselves.

That way, should the option be exercised, the broker will be able to deliver the shares at the price and on the date specified.

Accordingly, as more investors have bought calls in Gamestop, the share price has risen.

What has generated the explosion in the share price in this instance, however, is an additional factor – which is that Gamestop had been the target of a number of ‘short sellers’.

A man walks past a GameStop store in Austin, TX, U.S., March 26, 2018
Image: Gamestop has faced pressure from an activist investor

These are investors who bet on a fall in the price of a particular security such as a stock or a bond.

They typically do this, for example, by borrowing shares in a particular company and then selling them.

If the share price falls, they will then buy those shares back at the lower price, sealing in their profit.

The shares are then returned to the original investor from whom they were borrowed.

In the case of Gamestop, because a number of investors have assumed its market will evaporate, they have been short-selling or ‘shorting’ the stock.

Accordingly, when Gamestop’s share price rose as those who had sold call options bought shares in the company to protect their position, some short-sellers realised they would need to do likewise.

There was, in market jargon, a ‘short squeeze’.

The shorts were forced into buying the shares as well – squeezing the price higher.

FILE PHOTO: Traders wear masks as they work on the floor of the New York Stock Exchange as the outbreak of the coronavirus disease (COVID19) continues in the Manhattan borough of New York, U.S., May 27, 2020
Image: Financial regulators fear some small investors may be in over their heads

What prompted these investors to look at Gamestop in the first place?

The answer to that appears to date back to September last year when the activist investor RC Ventures took a 12.5% stake in the business and began agitating for change – specifically for the business to step up its online activities.

It succeeded in getting three of its representatives onto the Gamestop board in January, including its managing director Ryan Cohen, founder of the online petfood business Chewy.

For those on the winning side of the trade, the rewards have been colossal.

One investor posted screengrabs on the Reddit community WallStreetBets suggesting he had turned an initial investment of $53,566 into one worth more than $25m at one point this week.

Adding to the joy of those investors – which includes another group on the social media platform TikTok – has been the discomfort of those on the losing side of the trade.

Short-sellers are loathed by many private investors for the positions they take against some businesses and, in the process, contributing to falls in their share price.

Many of these are hedge funds and a number of them have been caught out badly by the surge in Gamestop shares.

They include Citron Research and Melvin Capital Management.

Buying by both, to close out their short positions, are thought to have contributed to the sharp share price spike this week and Melvin, which is thought to have seen at least a third of its capital wiped out during the last week, is reported to have received a $2.75bn bail-out from two more hedge funds, Citadel and Point72 Asset Management, to tide it over.

Happiness at tweaking the tail of these short-sellers is not, however, confined to the small investors on Reddit, Facebook and TikTok.

Elon Musk, who in the past has frequently railed against hedge funds for driving down the price in shares of Tesla, tweeted on Tuesday evening: “Gamestonk!!”.

Such is the frenzied atmosphere, however, attitudes in this field are as polarised and conspiracy theories are as rife as in US politics.

When CNBC reported today that Melvin Capital had closed its short position in Gamestop, one user on the WallStreetBets community on Reddit posted: “Melvin didn’t close their position…They’re trying to trick you into selling.”

The user urged others to “HOLD THE ****ING LINE”.

This phenomenon is not just being seen in Gamestop.

Private investors have alighted on a number of bombed-out stocks in recent days, including the enterprise software provider Blackberry, whose shares are up 185% so far this year; the retailer Bed, Bath and Beyond, whose shares are up by 108%; cinema operator AMC, whose shares are up 134% and the software company Palantir, which is up 50% so far this year.

File photo of Blackberry sign seen in front of their offices on the day of their annual general meeting for shareholders in Waterloo
Image: Shares in Blackberry are up 185% this year

A renaissance in private share ownership? It is tempting to see it that way.

But the hedge funds are not the only ones to see this as an unwelcome development.

Financial regulators have been taking a close look at platforms like Robinhood for fear that some of its customers may be in over their head.

Vlad Tenev, the co-founder of Robinhood, dismissed these concerns today, insisting it was wrong to view the arrival of more retail investors in the market with dismay, arguing that owning shares was as much a part of the American dream as home ownership.

Bulgarian-born Mr Tenev told CNBC: “We believe in education and that people should be informed [about investing] and that is something we will continue to invest in.

“We are one of the few companies that treats customers like adults when we hear from customers that other financial institutions tell them they shouldn’t be investing their own money.”

He said he refuted “this idea that all retail investors are unsophisticated”.

That may well be.

But this saga has uneasy echoes of how the dot-com bubble expanded and then burst two decades ago.

It is hard not to think that some investors are going to get very badly burned at some stage.

 Sky News

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