GameStop: Not over yet

The GameStop saga grabbed headlines this year as we saw retail investors going head-to-head with Wall Street in an unprecedent series of events. Since then it has been brushed aside by many as an event that has been and gone, but the reality is, this is just the start.

What happened last time?

27th January 2021, GameStop (GME) peaked intra-day at $483 before closing at $347.51, this was due to a well-coordinated short squeeze. But what exactly is a short squeeze? A short squeeze is actually a lot simpler than it sounds, to understand it though, we need to first know what shorting is. To short a stock, say GameStop, you would need to borrow that stock from a broker and then immediately sell it in the market. Then, hopefully for you, the stock will begin to fall in price and you can buy back the same shares at a lower price. Now you can return the borrowed shares and pocket the difference in price as profit.

In January, there was extremely large short-interest by hedge funds for GameStop and the “apes” of Reddit (Yes, they do call themselves this) saw this as an opportunity to try and orchestrate a short squeeze. This community began buying GameStop shares, and lots of them, this sent the stock price higher and higher. Soon enough the hedge funds holding these short positions began to receive margin calls on their positions. A margin call is when an investor’s margin account goes below the maintenance margin and the only way to meet a margin call is to either deposit more funds or add securities. The hedge funds therefore were forced to cover their short positions by buying GameStop stock at a much higher price, incurring heavy losses. At the same time, since they are buying more stock this is sending the stock higher creating a snowball effect. Ultimately leading to GameStop peaking at $483.

After GameStop peaked it fell dramatically to around $40 in mid-February and many thought it was all over and this “meme” stock was just that, a meme. The hedge funds laughed at investors losing all their wealth and they went back to shorting this fundamentally bad company in peace. But to the shock of many in the market, GameStop has bounced back with a second peak of $360 in early March. You may now be thinking how is this even possible? Isn’t this just a meme stock? How have hedge funds let this happen again? If you are thinking any of this you are not alone, but there is a lot more to this “meme” stock than you may think.

What caused the recent rally?

The “apes” of Reddit believe the recent rally is just the beginning of the mother of all short squeezes and is being fuelled by what is known as a Gamma squeeze (a lot of squeezes, I know, but stay with me). To understand a Gamma squeeze we need to get to grips with call options.

Call options are financial contracts that give the holder the right, but not the obligation to buy the underlying asset for a certain price (strike price) in the future. In this case the underlying asset is the GameStop stock. An investor will buy a call option if they believe that GameStop price will rise. If GameStop price rises above the option strike price, then the investor can exercise the contract and buy GameStop for cheaper than the current market price.

When you buy a call option, it does not just come out of thin air, you are buying it off someone, this someone is usually a market maker. Market makers provide liquidity to the markets.

When you buy a call option off a market maker, the market maker that sold it to you is in an uncovered call position. The market maker will lose money if the stock rises in this position. Therefore, market makers will cover their position by buying the stock. When market makers are in this covered position, they will collect a premium for selling the contract and then have no risk.

Now there is much more to this process, but I will not bore you with the maths of it all, just understand that when a market maker sells a call option, they will buy a certain amount of the underlying stock to cover their position, this amount will increase the closer the stock price gets to the strike price.

Now that we understand that we can get to the juicy part of a Gamma squeeze. A Gamma squeeze occurs when the price of the underlying stock increases, market makers are forced to buy more of the underlying stock as it reaches the strike price. This will send the stock price higher and as the price trends higher, investors will buy more call options as they will be able to make more profit. This all leads to another snowball effect like the short squeeze.

On 28th January 2021 rose 92%, on that same day nearly 1.5 million call option contracts were traded compared to just 178,000 put options (put options gives the holder the right, but not the obligation, to sell an asset for a certain price). This could hint towards the Gamma squeeze mechanism heating up.

What next?

In the last week or so, GME stock price has fallen 30-40%, so why hasn’t GameStop gone to the moon yet? And will it ever? The recent pullback is believed to be because the hedge funds are fighting back. Hedge funds are the ones holding all these short positions, so a rise in the stock is bad news for them. As a result, they will do anything to keep the price down.

Hedge funds have dropped the price by shorting ETFs. ETFs are exchange traded funds and are securities that can track other assets and be bought or sold on the market. Hedge funds have recently borrowed huge amounts of ETFs with GME in and have since massively shorted the ETF. This means they have been selling the ETF and lots of it, driving the price of the ETF down and GME with it. This is a tactic used by hedge funds over and over again to try and counter the buying of GME.

I think this pullback will continue today (24th March) as last night GameStop fractionally missed earnings. Hedge funds have been ready to pounce on this and will start shorting the stock even further, artificially deflating the stock price.

GameStop may have pulled back recently, but this second peak is very interesting. But what is different about this second peak? It’s not just the increased interest in options fuelling the Gamma squeeze, but this time, big institutional investors are getting behind GameStop. Now it’s not just a Reddit community backing GameStop, and this will lead to hedge funds finding it harder and harder to manipulate the market and drive the price down.

If GameStop shares start rising again the Gamma squeeze may very well kick in for real, sending the stock soaring. If the stock can get high enough that it will then trigger margin calls for hedge funds, this is when the stock will really take off. This will once again trigger the short squeeze, but now it is being fuelled by the Gamma squeeze and this combination may finally see GameStop all the way to the moon. The level where I think it will really take-off, if it can even get to it, is the $800 mark.

Why is this $800 mark so important? Firstly, $800 is the strike price of many of the call options out there and so as the price draws closer, market makers will have to buy more and more of the stock sending it higher once again. Secondly, at $800 a large proportion of put holders will get margin called. Yes, you guessed it, this will trigger a short squeeze and I believe this will be the mother of all short squeezes.

Whether or not there is a Gamma squeeze or short squeeze or any squeeze for that matter, GameStop is turning itself into a much more attractive company which could make it a very good long-term investment. GameStop has recently announced a massive shift in its business plan with an aim of moving away from a traditional bricks-and-mortar business, instead heading towards e-commerce. When GameStop is now re-valued compared to its new e-commerce market, its inflated price may not look so crazy.

Concluding remarks

The GameStop story is far from over and I personally believe this is just the start. Hedge funds will do all they can to stop GameStop but retail investors, and now many institutional investors are backing it all the way. At the end of the day this is just all theory, no one really knows what is going to happen, the stock may never reach the astronomical heights predicted and even if he does it will be a very volatile stock in the meantime. However, at the moment the evidence is pointing in one direction…to the moon!

This article is by no means financial advice, I am not a financial adviser. If you are interested in GameStop, I heavily recommend doing your own extensive research.