GameStop And The Rationality Of The Irrational

Editor’s note: The following piece is from Identity Element, reposted with permission. You can read more from the site and/or subscribe here. It’s free.

Unless you have been under a rock the past week it is highly unlikely you did not hear the clamor regarding r/wallstreetbets. This decentralized community took advantage of a structural inefficiency in the stock market by launching a highly coordinated assault on heavily shorted names such as GameStop, forcing market makers to hedge their position at ever-increasing prices. In the wake of this volatility, brokerages such as Robinhood completely denied speculators (this is not investing to be clear) the ability to purchase additional shares of “meme stocks” on Thursday and is now under intense scrutiny from regulators and the public who demand answers. Volatility in specific stocks has cascaded into the broad market over solvency concerns, and this retail phenomenon has seeped into speculative instruments such as Dogecoin. The prospect of astonishing returns has captivated the minds of the public. Make no mistake – this is a proper s***storm by all accounts.

Now, I am going to attempt make sense of this nonsense.

The Weaponization of Stupidity

The origins of our story reside in a (no longer) obscure corner of the internet known as WallStreetBets (WSB) – a subreddit where users post evidence of extremely speculative bets that infrequently pay off handsomely. Back in 2019, a member of this forum, u/Deep****ingValue (DFV for short), began posting daily updates of a $50,000 YOLO bet wagered on GameStop call options. As the months passed, DFV’s modest wager grew to be worth $3.1 million on December 31, 2020, and the WallStreetBets community began taking notice. You can literally see WSB’s progression of interest in the GameStop trade – there were only 76 comments on DFV’s first update, versus 19.3k comments as of DFV’s last update on this position (and here is a link to all of DFV’s updates).

The WSB community identified that institutions were massively short GameStop stock, to the tune of ~140% of GameStop’s outstanding shares – which implies that for every share someone was long, someone else was short 1.4 shares. This is technically impossible, but with some financial engineering, a short position can be incepted without the need for owning the underlying share itself. These positions are marked on a dollar basis and function as a basic financial derivative. Consequently, while anticipating GameStop’s move would have been challenging a priori, the volatility it has realized in the past month is not particularly surprising due to the mechanics of short covering.

Indeed, WSB was keenly aware of these mechanics and attempted to exploit them by disregarding the notion of “value.” The basic principle of the GameStop squeeze is that gamma forces entities who are short options to adjust hedges in larger quantities, and at higher frequencies, the closer an option gets to reaching its strike. WSB collectively realized that by aggressively purchasing shares of GameStop, irrespective of the company’s underlying value, they can force dealers who had accumulated short positions to continue purchasing GameStop shares at higher and higher prices due to the forces of delta and gamma.

The price action brought scrutiny from establishment figures on CNBC, expressing their outrage at GameStop’s detachment from underlying value. [1] This outrage is only exacerbated by commentators’ inability to reason with the WSB crowd, for WSB robbed the establishment of their ability for denunciation by preempting it. Here is its remarkably satirical rallying cry:

The WSB network has internalized all forms of criticism by admitting its crime in broad daylight; they know they are idiots – they simply do not care. It is impossible to reason with the unreasonable. This dynamic only exacerbates establishment disgust with the situation.

What WSB’s detractors fail to appreciate is that this trade had nothing to do with GameStop’s value. GameStop was simply a medium in which WSB could take advantage of a structural inefficiency, and by definition, this demanded that value be disregarded entirely. This trade is no different from other targeted deployments of capital in years prior (think Soros and the pound). The difference rests in its composition – WSB has revealed that concentrated capital pales in comparison to the ubiquitous deployment of capital from an anonymous collective. The value of networks is the currency of a digital world, and consequently, WSB just became one of the world’s most valuable networks.

The value of networks reared its head again on Friday as brief pockets of speculative manias appeared in cryptocurrencies such as Dogecoin. Dogecoin’s rally highlights the flaws of our hyperconnectivity – individuals with the largest followings in connected networks can mobilize others who will fall in line, no questions asked. The propaganda machine on Twitter was working overtime Thursday night and into Friday – accounts were propagating the idea of this rags to riches story while others attacked those who could even fathom selling.

The recommendation to “invest” in Dogecoin was driven by large social media personalities who may have accumulated large positions in the cryptocurrency prior to Thursday morning, and could have capitalized on the public’s recent infatuation with large gains by promoting a get-rich-quick narrative to the masses who were compelled by Dogecoin due to the meme stock phenomenon. This is a classic pump and dump scheme – idiots leading the stupids. There must be consequences for those who have manipulated public perception in Dogecoin in the event it fails spectacularly, otherwise, this exploitation will persist well into the future and likely with larger consequences. But the hyperconnected network of social media proved fruitful for this pump and dump scheme, as evidenced by the price action below.

Not too dissimilar to the social networks driving the Dogecoin move, the value of the WSB network rests in its ability to coordinate the deployment of capital. However, the vigor of this collective assault would not have been attained had it not been for WSB’s underlying mission – to stick it to the institutions. Reading the P&L statements of firms that lost money on this short position is nothing short of a catastrophe and it opens an entirely different suite of questions regarding hedge fund’s fiduciary responsibilities. It is truly remarkable that some firms have been completely obliterated in the wake of this, but it is untrue that WSB is the sole benefactor of the meme stock phenomenon. WSB was likely a pawn in a much more complex game.

Herding Sheep

The GameStop trade was peddled on social media by large personalities (in a similar fashion to the Dogecoin saga) over the course of the past week. Speculators relentlessly purchased GameStop stock in an effort to continue driving its price up, taking advantage of the gamma effects alluded to earlier in this piece. This all came to a head Thursday morning when Robinhood surprised the world by announcing it was no longer enabling users to purchase shares of meme stocks.

This was a calculated and malicious attempt to stop the music by Robinhood – the company was keenly aware of what it meant: the death of the meme stock trade. Short squeezes are predicated on relentless buying pressure; if you remove one’s ability to continue purchasing, demand is completely removed from the supply/demand equation and the price is left to crater. This is precisely what happened on Thursday.

Robinhood’s decision marks the second time this month that a large technology company decided to inhibit its users from operating freely on its platform, with this decision having serious economic consequences. The company’s name is an oxymoron – Robinhood garners significant income from fees it generates by streaming feeds to large institutions. Since these firms can access Robinhood’s order flow, they can preempt orders that are placed by Robinhood users, slightly adjusting bid/ask spreads accordingly. The net effect to a single user on Robinhood is minimal, but over the course of millions of shares transacted, the value extracted by firms from Robinhood’s user base is significant.

Consequently, given Robinhood’s historical misalignment of interest, it is hard to believe that the decision made this past Thursday was to protect its investors. I personally do not care to hear about the collateral requirements Robinhood allegedly failed to maintain – if you are not capitalized well enough to enable users to continue operating in the manner they had been, do not offer users access to that mechanism until you are.

The SEC is now investigating Robinhood’s decision, and its ruling will dictate whether we see these moments of extraordinary volatility occur in the future. If Robinhood is deemed in the wrong, then this mechanism of targeted speculation in single names will likely become a fixture of the future. However, given that Robinhood raised $1 billion after its decision to restrict the purchasing of meme stocks, coupled with Citadel and Point72’s decision to invest $2.75 billion into Melvin Capital – the hedge fund hit hardest by the GameStop saga – one must ask themselves: is this truly the proletariat revolution WSB believes it is? Or are retail investors simply pawns in a much bigger game, leveraged by the players they sought to destroy (re: Major AMC Shareholder Silver Lake Sells Entire Stake for $713 Million)?

Disclaimer
Opinions expressed are solely my own and do not express the views or opinions of my employer. The above references an opinion and is for information and entertainment purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.