GME’s Squeeze Explained in Simple Terms

Hackernoon breaks down what the GME short squeeze is all about, why it is happening, and how it might end

(Hakcernoon)I have traded options both professionally and personally for over 10 years by now. I will try to explain in simple terms what is happening with GME, and yes, whether you should buy some calls to YOLO or not.

By now you must have read that GME, a failing physical game distribution company in the age of Steam and Epic Store, has ripped 18x in just a month. There is plenty of articles how /u/deepfuckingvalue turned a 50k investment to almost 50m by now.

First off, this has nothing to do with GME per say. This is not a fundamental play on the company’s prospects. Rather, it is a bet on market microstructure, and an amazing one at that!

GME has had the jet fuel of two of the market’s greatest disruptive forces combined all in one: a short squeeze, combined with a gamma squeeze.

There are three characteristic that have made this possible:

1- Short interest — short interest is how much of the stock’s publicly available float have been borrowed and sold on the open market. GME has a float of roughly 50m shares. Almost the entire float has been shorted for months. This makes it a perfect candidate for a short squeeze if the borrowers must give back the shares they had borrowed (also known as covering your short). This can happen if the lenders call back their shares, or most often, if you lose money on your existing short positions so that you have to buy back the shares to bring your account into good standing.

2- Active Option Market — Options are inherently levered instruments. The buyer of a call option has the right (but not the obligation) to buy a certain asset at a predetermined price, usually at a fraction of the face value of the options. On January 19th when GME was trading about $40 a share, you could have bought a call on GME with a strike of $60 expiring on January 29th for $2. That gave you the right to buy GME at $60 on January 29th regardless of the price. At the time of this writing, GME is trading around $300, meaning that your expected profit is approximately $300 — $60 (what you will pay at expiry) — $2 (what you paid for the option) = $238.

Now the sellers of options only care about the volatility of the underlying and engage is an activity called “delta hedging” to neutralize the impact of asset movements on the options. This is not easy to explain without getting into the mathematics of how options are priced, but just know this: The seller of an option (short gamma in trader terms) will virtually always trade in the direction of the market. That means the sellers of the stock options buy more stock when the stock’s price goes up, and sell more when the stock’s price goes down. This means that they will amplify market moves even further for large orders.

3- Illiquid Stock — Now this is where the first two points meet and why the move in names like GME are nothing short of extraordinary. The retail investors energized by r/wsb have been buying an enormous amount of call options on GME. As they buy call options, the sellers of the options have to buy more stock to “hedge” themselves given that the price has been going up. GME’s stock is quite illiquid (meaning hard to find) given the high short interest.

See where this is going? It means that there is a feedback loop as more retail traders buy more GME call options, but there isn’t enough stock around to buy, so you have both the shorts covering their positions, plus you have option sellers who have to buy more stock to hedge themselves, pulling the price higher, and then it just repeats itself.

Normally in deep liquid markets the impact of all this is manageable. The beauty of the last few weeks is that the retail traders led by deepfuckingvalue have understood that in order to repeat this they only need to find stocks that have these three characteristic: high short interest, active option market, and illiquid stock.

Should I join the crowd and buy some calls on GME, or AMC, or any other r/wsb stock now?

As with any investment decision, the only way to say anything meaningful is if there is a full portfolio context. This rotating squeeze can continue for a few more days or even weeks, but unless you have a deep understanding of market microstructure and how derivatives work, I would recommend shying away from putting any real money to work here.

How will this end?

This is a worthless forecast, but I will do it anyways: It will end up with GME crashing back down. Right now, we are at “peak hype” so it can certainly go up to over $1000 a share, but for a company that is currently at 25bn market cap, with 5bn of revenue (and falling for years), and negative net income there is no justification for the price. This forecast is worthless, because I cannot tell you when it will happen, and that is all that matters.

Should I buy call options?

Options are a valuable instrument in most portfolios, but they are complex products and should not be traded without at least a basic understanding of how they work.

Now before you jump headfirst into buying options, just know that on average the buyer of an option is guaranteed to lose money over time. There is about three decades of proven track record on this phenomenon called Variance Risk Premium.