Image by Luiz Jorge de Miranda Neto- Luiz Jorge Artista from Pixabay
2021 sure picked up from where 2020 left off. As if things couldn’t get any crazier than a global pandemic, a group of retail investors seemingly organized an epic short squeeze in GameStop Corp’s stock (GME) so violent that it bankrupted a $12.5 billion hedge fund. To be sure, a lot has been said on the topic. I certainly learned a lot about the technical aspects of what transpired. However, I learned a lot about myself too. The GME event triggered some strong emotional reactions. These helped surface some deep-seated biases which was an opportunity to analyze them and improve my thinking process.
Markets have a way of expressing the culture’s dominant philosophies. After all, they’re just collections of human behaviors. Today, postmodernism and nihilism are commonplace. The recent episode with GME illustrated just this. Specifically, a nihilistic narrative took root early in the absence of facts. It was a telling sign of the times.
GameStonk
GME is, by far, this young year’s biggest investment market story. GME is a video game retailer. Faced with many fundamental challenges, its stock was heavily shorted and declining since late 2013. However, something incredible happened. GME’s stock price rocketed up from $17—where it began the year—to nearly $350 in a matter of weeks; hardly normal behavior! However, this dramatic move did not result from some surprise strategic shift. Rather, the exploitation of a volatile stock market structure uncovered by some savvy retail investors (allegedly) on the Reddit social media platform, r/wallstreetbets (WSB), was to blame.
On the surface GME is a modern-day tale of David versus Goliath. It’s a story of the underdog, individual retail investors, taking down a mighty, short-selling hedge fund. The WSB crowd played David; Melvin Capital Management LP (Melvin Capital) was Goliath.
The Suits!
The WSB plan was simple: buy large quantities of GME stock and call options. The heavy short interest meant that as GME’s stock price rose the short sellers would be forced to cover their trades and compound the upwards pressure. Buying call options supercharged the effect (by creating a gamma squeeze). It was a tried and true strategy. (I explained this more in a recent interview found here.)
The maneuver worked like a charm. Within a couple of weeks GME’s stock price exploded upwards: to $50, $100, $200, $300, and flirted with $350! The shorts looked trapped. As the share price climbed so too did their loss. Soon, Goliath was mortally wounded. Two prominent hedge funds, Point72 and Citadel, stepped in to rescue Melvin Capital from insolvency.
GME’s stock price exploded upward from around $17 at the start of the year to nearly $350 as the short squeeze intensified
However, shortly after thrown this lifeline, the strangest thing occurred. Without warning, Robinhood, the WSB crowd’s brokerage of choice, restricted trading in GME (and others with a similar dynamic). This practically ended the WSB maneuver and profits. What possibly could be the cause for such a surprise? It was The Suits! They had had enough losing. It was time to step in and protect their turf.
“The Suits” is a phrase popularized by the founder of Barstool Sports, David Portnoy. It’s a metaphor for the connected cronies whom seemingly control the global economy from behind the scenes. You see, Goliath rigged the investment markets. He always defeats David. The little guy never has a chance. Here, this view postulates, Citadel and Point72 were using their connections to stop the short-squeeze and protect their new investments in Melvin Capital. What else could it possibly be?
Emergency Press Conference – Everybody On Wall Street Who Had A Hand In Today’s Crime Needs To Go To Prison pic.twitter.com/aKr8aPbB3Z
— Dave Portnoy (@stoolpresidente) January 28, 2021
Something Else
This narrative quickly took off. I’ll admit, my mind went there too at first. Remember, the financial markets are heavily regulated. This wouldn’t be the first instance of an entrenched institution weaponizing regulatory capture against competition.
However, I was quick to catch myself, and I’m glad I did. There simply was no evidence of foul play yet. In fact, there were no facts available at all to evaluate. Might there be other explanations, I thought?
Sure enough, this popular narrative was exposed as patently false. No, there was no conspiracy. The Suits hadn’t pulled any strings to manipulate trading. Rather, commonplace risk management practices were at play.
GME’s explosive stock price move sent its volatility through the roof. Volatility is statistical description of a stock price’s range; the greater its move, the larger its volatility. GME’s rapid price change wreaked havoc throughout the “plumbing” of stock trading operations. Because of the various time lags involved in trading stocks, firms providing the vital services that enable stock trading assume various forms of credit risk. They employ risk management strategies to protect their businesses and ensure smooth operations. Volatility is a critical input for these risk models. As GME’s volatility rose so too did margin requirements. Tony Greer of TG Macro expertly explains what happened here.
GME’s stock volatility exploded, leading to margin calls throughout the “financial plumbing” of stock trading operations
Robinhood’s predicament was commonplace. It was short on cash due to GME’s volatility. Connected hedge funds and The Suits played no part.
Khakis, Not Suits
So there you have it. There is no cabal of well-connected financiers tipping the scales in their favor (at least not in this case). However, the extent to which this narrative took hold surprised me. Don’t get me wrong, I’m a sucker for a good David versus Goliath story. I wanted to “go there” too. Thankfully though, I caught myself before getting too wrapped up in the seductive narrative. Quite frankly, it didn’t take much digging or time to debunk it.
Why did so many and well-intentioned people leap to this conclusion? To me, philosophy is the answer; the GME situation highlighted the huge impact it plays in our thinking, whether we know it or not. Humans are conceptual animals. Our mind’s function is to integrate facts into ever-widening concepts. It seeks to create order out of a seemingly disorderly world to expand our efficacy and ability to thrive. An unfortunate side effect is that we’re prone to mistakes.
Nihilism is one of the dominant philosophies I’ve observed this market and its participants to express. This negative worldview subconsciously leaves us vulnerable to accepting notions of futility. Narratives of rigged investments markets fit neatly into nihilism’s doctrine: What, you didn’t actually expect David to beat Goliath did you? By hook or by crook, Goliath always wins, remember; always.
Personally, I find such nihilistic views to be empirically wrong. History is riddled with people beating the odds by using a better analysis, understanding, or framework to earn fortunes. While rare, they are nonetheless real and possible in this world.
Check Your Premises
In my experience, nihilism is wrong, both in the markets and in life. Given how prevalent it is, I try to keep extra vigilant to my mind wandering in such directions. This can be difficult when it’s so commonplace. Like a fish in water, it’s hard to discern the philosophy in which we’re swimming.
What transpired in GME’s stock over the past few weeks was truly astonishing. The short squeeze was of epic proportions and Robinhood’s sudden trading halt came as a surprise. To be sure, it captured many imaginations. However, the facts ultimately proved the nihilistic narrative that took hold false. Markets weren’t rigged. Rather, commonplace operational decisions underpinned Robinhood’s decision to limit trading in GME’s stock.
For me, GME was an educational moment. It was another chance to test my emotional intelligence. Luckily, I passed this time and my awareness will only make me better for the next situation … and there will be a next time. Hopefully, then too I’ll recognize my biases and either avoid a losing trade or enter one profitably.
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frankly, i just want to be able to be on the right side and profit from it as long as it is legal.
you write very well for a finance guy – please don’t take it the wrong way. i am a horrible as i can barely write my own name.
love to grab beers with you one of these days.
Thanks for the comments. I hear ya on the profit part. There’s a lot of mixed/muddled thinking in the investing world. I started this blog to help improve mine and trade better. WRT writing, it’s a skill that anyone can improve with the proper effort, like anything (just look at my earlier articles!). And as for for beers: I’m always game to throw back a few with any reader!
Except the DTCC wrote a letter saying that they waived all such requirements of Robinhood and other Brokerages that same morning due to the volatility. So…. I don’t quite follow the argument here. Time will tell if there really was or wasn’t “foul play”, but there truly was no legal or financial reason to halt trading due to the suggested items.
Right, but my understanding is that the DTCC waived the collateral requirements only after Robinhood agreed to stop trading GME – because of GME’s extreme volatility and Robinhood’s low capitalization (see here and here for example). Am I wrong?
I think it is ironic that you have said that there is no foul play, while providing information that there is foul play. This incident was another example of being money being bailed out because they could not pay their bill.
I am not going to waste a lot of my time arguing with you about foul play, but I will provide what I saw as foul play here. Delisting securities from the open market. Not allowing people to buy (which you did not mention that by being able to buy, the stock would not be able to trend downward as harshly). The stock was primarily halted on GME’s rise, but not fall. I am familiar with the fact that when stocks are crashing hard, they get halted to protect people from losses (somehow, GME did not get this treatment). You forgot to mention the fake news that spread through the news, the smear campaigns against GME (these fall under providing misinformation, which you should know is illegal). You also have not mentioned that the parties in question during Congress lied under oath to protect themselves (now why would they do that). Clearinghouses did not allow for trading because and I will quote them “we cannot afford to pay the winners in this trade”. I understand that there was a liquidity problem, but those clearinghouses and brokers had no issues allowing institutional money to make it possible for the company to be almost 150% short (By the way Naked shorting is still illegal). Why hasn’t the DTCC stepped in and said anything about HFT firms? I understand that there is a two day clearing period, but the DTCC does not seem to have any problem allowing these funds to trade rapidly, and all day. This has also led to a fundamental problem of shares being failed to deliver for GME and those are in the billions, so where are all those shares for those respective clients?
If you are going to write an editorial piece about something like this, I would implore you to please do more research. There is also plenty of evidence floating around, you seem to have left it out.
Hello Michael, thanks for your comment and perspective. You make lots of allegations here about what the DTCC does and doesn’t do, about naked short selling, who’s lying and why, etc. Just ask, is it possible that reasons other than “markets are rigged” might be at play? For instance, my understanding is that margin requirements were significantly increased, not that trading was halted completely. Also, that the HFT naked short selling is not what it’s made out to be (check out the interview with Tony Greer linked to in the article). I don’t claim that markets are free, just that they’re not as crony as popularized.
Come on, man. When the hedge funds couldn’t trade in ’19 because of liquidity, collateral, whatever, the fed reserve jumped in with how many billions, just to make sure they could trade.
Not enough collateral for retail to trade gme, the fed says that’s just tough for you fellas.
And now we’re hearing about natgas traders last week who didn’t have enough collateral to trade and voila!, somehow they were able to keep trading.
Only one slice of people got shut out of the mkt when collateral got slim in these three episodes.
Thanks for reading and for you comment. Look, I hear your frustration. Cronyism is despicable and a real problem. There’s just little evidence that it came into play in this situation. Also, I’d bet that there were plenty of hedge funds (if not mostly) on the long side of the GME trade, disguised as retail or not. Please, don’t stop fighting against cronyism, there’s lots to do on this front. But you do the cause better by picking better battles.
Tested me too man. What a crazy ride. Thanks for writing! Keep it up!
Thanks for your comment Ryan. What an understatement! It took me a while to unravel the story and I’m glad I did.