A hedge funds’ drama is currently unravelling on Wall Street, as veteran hedge funds are squeezed out of their short positions by “amateurs.” For once, retail traders have beat Wall Street at their own game and are winning by a long shot.
It all started with “WallStreetBets” – a subreddit group which functions like a trading forum where participants discuss stocks, options and exchange trading-related tips and stories. Founded eight years ago, WallStreetBets counted around two (2) million members, but that has doubled this past week.
It all started with a company called GameStop (ticker $GME), a favorite stock for hedge funds specialized in selling stocks short. When shorting a stock, the seller is bound to make 100% of the investment should the stock go to zero – in plain English, if the company goes bust or bankrupt.
The problem for most of these hedge funds is that WallStreetBets decided to take the other side of the trade. And the difference is huge – while the losses when going long are limited to the downside (e.g., the stock cannot drop below zero), the losses for the short sellers are unbounded to the upside.
Here is how it goes – there is both a short squeeze and a Gamma squeeze in play, a deadly combination for short-sellers.
What Is a Short Squeeze?
When short sellers bet against a stock, they borrow shares from the brokers with the promise of returning the shares in the future. The aim is to make a profit if the price of the shares goes down.
For example, if a short seller sells a stock at $50 and the price goes to $40, the seller may decide to take profit. To do so, the short seller will close the short position by returning the shares to the brokers and making a profit of $10 on the difference.
But what if the price goes up and not down? Here is when a short squeeze comes into the picture.
Let’s say that the price of the stock goes to $100 from $50. When the shorted asset experiences a rapid increase in price, the short seller is forced to cover the short positions by buying the stocks at the market and returning them back to the brokers. More precisely, the short seller adds fuel to the fire, and so the price rises some more.
In other words, the short seller is forced to exit the trade by buying the stocks to cover their shorts. In the case of GameStop, yesterday the WallStreetBets group generated a $5 billion mark-to-market hole in short sellers’ pockets. And that was only yesterday.
The epic short squeeze also benefited from another thing that went wrong for hedge funds – a Gamma squeeze.
What Is a Gamma Squeeze?
A gamma squeeze belongs to the “dark” world of derivatives trading. Why dark? Because derivatives were to blame for the 2008-2009 Great Financial Crisis. One of the principles that WallStreetBets members stand for is – how come investment houses were bailed out after the crisis, while the regular Joe paid the bill? And now, the same weapons are used to “punish” the wealthy on Wall Street.
Before discussing the Gamma squeeze, it is worth mentioning that this is a phenomenon that belongs to options trading. Options are derivatives that fluctuate based on the underlying asset’s movement (i.e., the stock that has been shorted by hedge funds). The thing with these options is that while they belong to a different market, they have ripple, indirect effects on the actual stock market price of the underlying asset. Here is how.
Options are either call or put. If you buy a put option, you expect that the price of the underlying asset will fall. If you buy a call option, you expect that it will rise. Remember that these are nothing but contracts, and the cost of entering the contract is called the premium.
But when you buy a call option (i.e., expecting that the market will move to the upside), someone has to sell that option to you—introducing the market-maker. The market-maker thinks twice about the risk exposure it has, especially if the price of the stock, indeed, moves to the upside. As such, the market-maker will choose to hedge its exposure because if the price rises above the striking price, the market-maker will take a loss.
To hedge against such a scenario, the market-maker goes into the actual market and buys some stock for itself. The more the price rises, the more the market-maker buys too. And this is the indirect effect of an option contract on the actual price of the underlying asset.
Market-makers use the Delta, a measure of how much the price of an option contract moves in relation to a one dollar move in the actual stock. Gamma represents the rate of change. So in a Gamma squeeze, the more the Delta and Gamma go up, the more the market-maker is forced to buy the stock at market.
Breakdown of a Squeeze Timeline
It all starts with someone (i.e., hedge funds) having exposure on the short side of a company. If other traders think that the company is worth more than the current price, they may decide to buy the actual stock, buy call options, or both.
With every $1 rise in the price of the stock, the short-sellers suffer from both a short squeeze (short-seller must buy the stocks to return them to the brokers) and a Gamma squeeze (market-makers must buy the stock to hedge against the risk of the option being exercised in the money).
What Does This Mean for Investors?
Suddenly, the retail trader rules the market. When 2 million traders with small accounts trade in unison, they act like a huge fund on their own, with tremendous capital and resources.
Investors should care because, for the first time, retail traders could permanently change the stock market. We may be at the start of a new era in investing, where the power is shifting from institutions to individuals.