How Main Street stormed the Financial Capital - the GameStop Story
This week a group of retail traders took down a major hedge fund. The story involves high stakes drama, billions of dollars and one man’s willingness to go to the moon. The GameStop trade war will go down big in history, so grab a seat and some coffee. We have armed the rebels and the revolution has begun.
Long live Brick and Mortar
First, who is GameStop? Millennials will remember the retailer who would buy used video games for 25 cents, only to resell them at $25. This old establishment has +5,000 stores across North America. But the old brick and mortar retailer has not kept up with the times.
We’ll get back to GameStop in a minute. Let’s begin our story by introducing the key players.
The Wall Street Experts
Two contrarians take the first step
Our story begins with unknown contrarian investors. If you’ve watched the Big Short, then you’ll remember Dr. Mike Burry. He never wore shoes and was played by Christian Bale. In August 2019, Dr. Burry made an initial investment in this video game retailer. At that time, the company was trading at $4 per share and considered a “cigar butt” investment.
Dr. Burry is known for making obscure investments in unloved companies. In our case, esports has made billions of dollars with online gaming, while Gamestop was losing market share with physical stores. Less people were visiting the retailer everyday. But as in the Big Short, where Dr. Burry waited two years to bet big against the subprime housing market, he maintained a position in Gamestop until last week. Later we’ll discuss why he made this investment.
Now enters Ryan Cohen. Ryan is the cofounder and former CEO of chewy.com. He knows a thing or two about ecommerce. After selling Chewy.com to PetSmart for $3.35 billion in 2017, he took his money and invested in two stocks: Wells Fargo and Apple.
Financial advisors are against concentrated investment strategies. They recommend investors diversify every dollar. But that’s not how the rich get richer. Concentration creates wealth, diversification preserves it. Concentration is a recurring theme in the GameStop saga.
You see, Ryan decided to add one stock to his two-stock portfolio. In August 2020, Ryan bought $79 million worth of Gamestop stock. At the time he owned more than a ~10% stake in the company and sent an activist letter to the board of directors in November 2020. He received three board seats from his proposal. Don’t stop reading now.
Enter the short sellers
Every investor has a different motive. Just like every story has a hero and a villain. The Gamestop saga had similar opposing forces.
You see, large shareholders are required to disclose public stock positions. In early January 2021, a group of Robinhood investors found a gap in the financial markets. So began the public witchhunt of short sellers.
The largest short seller was Melvin Capital, a multi-billion dollar hedge fund run by Gabe Plotkin. Gabe is one of the best investors on the street. But not for long. He wasn’t ready to face Main Street head on for the stock battle of the century.
Since GameSpot was a dying brand, Melvin built a massive +$55 million short position against the company. Gabe was betting on the GameSpot failing and his company would profit from this bust. Later on we’ll illustrate how to sell short and what a short squeeze is.
Needless to say, when the stock went against them, Melvin needed $3 billion from Citadel and Point72 to meet its margin requirements. More on this later.
Chamath goes All-In
Late Monday night, Chamath Palihapitiya asked Twitter what investment he should make. With so much favored momentum from the GameStop shareholders, he decided to buy $100k worth of GameStop options at a $115 strike price. Keep reading, it gets more interesting.
So begins a wild rollercoaster ride for investors, regulators and speculators.
The next day, GameStop’s stock skyrocketed to $145 per share. He was well in the money. In fact, by Wednesday morning he sold his position for a 5x return. I know what you’re thinking. How did he make so much money so fast? Don’t worry we’ll get to that part soon.
It’s worth mentioning that Chamath donated his proceeds to the Barstool’s Fund for small businesses. More on the founder Barstool next.
The Rebels on Main Street
Or WSB as its known on the streets...of Reddit, has a self-proclaimed King and his name is DeepF*ckingValue. I’m serious. Look up his profile name. This mysterious user bought a mix of $50-100k worth of Gamestop ($GME) stock and options. In less than 12 months, his single stock portfolio skyrocketed to $47 million!
Yes, you read that right. $47 million in one year. On one trade. You can see why he may be the hero of this story. Main Street retail investors, or the Robinhood Rebels as I call them, worship this guy. I guess concentration really does work.
On August 21st, another retail investor went bullish on Gamestop too. At the time, the stock was trading at $4.61 per share or at $299 million. Below is a 5-minute clip on his investment research. He explains why the company profits from selling physical games and how the company will turnaround soon. Between you and me, this kid made more than a few bucks.
The Founder of Barstool makes a Bet
Now let’s introduce the people’s champion. Dave Portnoy is the founder of Barstool Sports. Peak pandemic, when all sports were shut down, Dave decided to stream daily day trading videos. He amassed over one million followers on Twitter during the pandemic. Betting millions along the way.
Dave is known for several things like his One Bite Pizza reviews. In early December, cities reinforced major lockdowns so he launched Barstool Funds to raise $20m for small businesses across America. He became the people’s champion.
But that wasn’t enough. During this short seller story, Dave intervened and made his own stake in the game. I think he’s down $2 million at the moment. In the past 72 hours, Dave has called out every billionaire hedge fund, the Robinhood CEO, and any regulators interfering with the free markets. This time he’s been an active voice on Twitter, defending Main Street investors.
Elon is Mooning
Between rocketships and electric cars, good ol’ Musky tweets an idea into existence. This time it was Gamestonks.
Yes, our infamous meme lord tweeted about the video game retailer on Tuesday afternoon, linking back to WallStreetBets. To add fuel to the fire, the Robinhood Rebels joined the cause and bought more GameStop stock.
You see, Musk has gone head to head with regulators in the past. In a previous tweet to take Tesla private (“Funding Secured”), the SEC fined the meme king $20 million for a stock trading violation. A speeding ticket for the climate change billionaire. He has no respect for the SEC and stands for the people.
Now for the story
Mid-January, Robinhood traders found a gap in the market. GameStop was overborrowed and there were very few shares in the public markets to buy. Which means, with a small investment in $GME, investors could move the stock higher.
Redditors first stumbled on this idea around January 13th. The stock began to creep up from ~$19 per share to $39 per share. Main Street had begun building a position. Remember, this stock was worth ~$4 per share in August 2020. Before Ryan’s activist letter, most investors weren’t watching the company.
Now begins the roller coaster ride
On January 19th, Citron Research tweets 5 reasons why Gamestop is a suckers bet. He attacked the Robinhood Rebels head on. Citron Research is a notable hedge fund that publishes good investment ideas on a regular basis. This was not one of them.
The Robinhood Rebels saw right through Citron’s research and started building a bigger position. With a small float, the GameStop stock began to ‘squeeze’ against short sellers like Melvin Capital and Citron Research. As the price begins to rise, borrowed shares begin to become more expensive. And by Friday January 22nd, the Gamestop was at ~$65 per share. More than 3x the price from three weeks ago. The shorts were hurting.
At this point, Citron Research was forced to exit their Gamestop position at $90 per share. This was well over a 100% loss for the first casualty.
WallStreetBets takes down Melvin Capital
Since the initial squeeze at ~$19, Melvin Capital had lost +$3 billion on this trade. The multi-billion hedge fund was overexposed to GameStop. So major investors like Citadel and Point72 had to cover their margin call for Melvin. But the game was far from over.
By Tuesday January 26th, the Gamestop was now hovering $147 per share and building momentum. Other stocks with high short interest ratios watched their prices more than double in a few days too. Now Wall Street was watching. So was the Robinhood/Reddit Rebellion.
WallStreetBets began targeting Gamestop and other stocks held by hedge funds. Companies like AMC, Nokia and Blackberry were all making a comeback. Koss Corp, the headphone maker, went from $4 to $108 in four days. All because Main Street investors decided to invest. Bigly.
So how did this happen?
Let’s begin with the short squeeze. Why did GameStop have a limited number of outstanding shares? As mentioned earlier, Melvin Capital and other hedge funds had a massive short position in the company. This has nothing to do with the retail business itself. Only with the stock that trades on a public exchange.
Short selling is betting a stock will go down in value. Investors can go to market, borrow shares from someone else and sell those shares. When the price drops, investors will buy back the shares at a lower price and you guessed it, profit from the difference. If the price goes up, then investors will lose money. Stick with me here because a short squeeze can be confusing.
A short squeeze can force investors to exit their position. You see, borrowing stocks creates unlimited loss potential and requires more margin. If the stock price keeps going up and against the original sales price, the investor will need to cover the difference.
For example, if you short a stock at $10 and it goes down to $8, you can buy it at $8 and make $2 in profit. But if the stock goes to $23, you need to buy back the stock at $23 and come up with the $13 difference. Now imagine this scenario but 10x the difference. Gamestop went from $19.95 to $347.51 in the matter of two weeks! That’s a multi-billion dollar margin call.
How does option pricing affect the stock price?
Options are derivatives of the underlying security. Yes, but what does that mean?
Options are priced based on the stock price. Different variables such as time and volatility go into pricing options. But let’s keep it simple.
Buying a call option gives you the ability to purchase 100 shares of a stock at a specific strike price. Remember, someone is always on the other side of a trade. So if you’re buying, someone is selling.
And 100 shares per contract is a lot of leverage. Every time the stock price moves, the option prices move too. But it’s the rate of change in that move that matters the most. This rate of change is called Delta. It is the first derivative. Did I lose you yet?
Well it doesn’t stop there. The rate of change in the Delta is called Gamma. Or also known as the second derivative. This is where option pricing gets complicated and affects the stock price. I know that’s a lot to take in, but bear with me now (pun intended).
Wall Street loves taking risk
Hedge funds and market makers use derivatives to manage risk. Or to take risks.
Buying an option requires a small premium to purchase the contract. At expiration date, if your option is in-the-money, you will take delivery of 100 shares. A simple transaction if the option buyer wants to own 100 shares of GameStop.
But if you are a market maker, you are hedging your position at every moment. Every time you buy a call option, the market maker will sell the contract and buy shares to maintain a neutral position. Options give market makers the ability to manage risk with less capital. But as the stock price changes, the market maker’s risk exposure changes as well.
If the stock continues to rise above its stock price, the market maker will have to buy back the stock at a higher price. If the stock price goes too high then the market maker will have a bigger loss.
The number of shares the market maker purchases is based on the delta of the option contract. Delta ranges from 0 to 1. As delta and gamma increase, the market maker is taking on more risk and needs more shares.
As investors buy more out of the money calls, the market makers need to buy more shares. Creating a never ending cycle of buying stocks to hedge a risky position. This created momentum with GameStop. Lots of momentum. If the stock skyrockets ‘to the moon’, we’ll experience a gamma squeeze pushing the stock even higher.
Main Street storms the Financial Capital
The Robinhood app makes it easy to buy option contracts. That purchase volume broke record highs this week. Forcing market makers to buy an unbelievable amount of GameStop stock to hedge their position. This drove the price from ~$70 to ~$350 per share, from Monday to Thursday.
So this week we had a short squeeze and a gamma squeeze pushing GameStop’s stock to an unbelievable level. The company’s market cap peaked around $26 billion with no material changes to the company except a high octane trading market.
This is not the end of the GameStop saga. Only the beginning. Robinhood and other brokerages stopped trading for several volatile stocks like GameStop on Thursday. Once the stocks were halted on Robinhood, GameStop fell more than 50% midday to ~$200. Retail investors had begun moving their assets to other brokers like Public.com. It seems that Redditors on WallStreetBets still believe in GameStop and will continue buying.
There’s no telling how this story will end. What I do know is many uninformed retail investors will get burned from the volatility. But they may take down one or two more hedge funds and show Wall Street who’s in charge.
Long live the king.