Over the last few weeks GameStop has become one of the biggest short squeezes in history, trading around $2.80 back in April 2020 to over $500 a share towards the end of January 2021. While most of the move has been in a few short weeks towards the end of January, GameStop’s journey to this point has taken nearly two years.
GameStop’s core business of selling video games has been in terminal decline for years, with the share price declining consistently from late 2013. The first real mentions of a GameStop bull thesis started popping up on the WallStreetBets message board on Reddit in early 2019. These ideas were premised on the cash position of the business, but the thesis didn’t gain any traction at the time and the share continued to tumble through to the middle of 2019. Perhaps the initial turning point for GameStop was the disclosure that Michael Burry, the investor famous for shorting the housing market in 2008 to which the movie The Big Short was based off, disclosed he was long GameStop. It was around this time that the first posts appeared about how one day there could be a short squeeze in the share if the company used its cash reserves to buy back its own stock. The idea of a short squeeze was again pushed by Reddit users, for the first time successfully, in April 2020 and the share price rallied before stabilising again. The next big kicker for GameStop came about 6 months later when the CEO of Chewy, Ryan Cohen, disclosed a position of 5.8 million shares in the company. Cohen’s company Chewy has been extremely successful since going public and, unlike GameStop, its success comes from the internet rather than brick and mortar stores. From this point forward the idea of squeezing GameStop’s share price gained momentum and continued into 2021, and that’s when the fireworks started.
There are a number of factors that made this rally different to others. While the use of message boards to exchange stock ideas is nothing new, zero commission trading and the ease of option trading were big factors in this rally. The scale of option buying, in particular short-dated and deep out the money call options, caused what can be called a gamma loop. This is where an investor buys a call option and the price of the stock rises, forcing the counterparty to buy the stock in the market to hedge themselves, and thus further pushing the stock higher. This then requires further hedging which pushes the stock even higher and so on. This happens the same on the way down when hedges are taken off, creating violent upward and downward moves when there is a lot of option trading in a stock. Further reasons for the rally have been the record high short interest, some US hedge funds being overleveraged, and mainstream media fuelling the rally with people such as Elon Musk tweeting his support of day traders in GameStop.
While events around the stock are still unfolding, it is uncertain how or when the GameStop story will come to an end. But lessons can already be learnt from the effect large scale option trading has on the market, the risk of excessive leverage and that of having a proper risk management framework.