Gamestop: Power to the Market Players (Part 1)

Well, unless you were under a few different rocks on Friday, you probably saw this at some point.

Aww, look at the lil guy go.

Apparently we all decided it’s 2006 again, because the hottest tech stocks around are $GME and $BB. I can’t wait until we can use AIM again and I can break out my Zune. So what’s going on exactly?

If you’ve been anywhere in the trading universe, it’s been partly a meme and partly a higher calling to long $GME since about July/August 2020, when everyone suddenly realized the short interest on $GME actually exceeded its available float. In English, this meant that there were more shares sold short (a strategy to benefit from the stock price going down, this involves borrowing a share to sell with the intent to repurchase it at a lower cost later) than actually available to buy. How does this happen exactly?

This can happen one of two ways:

1. Naked shorting — This is a mostly illegal practice in which an individual or institution first sells shares without locating that they well, actually exist. This is fairly sneaky, but works as long as they can find the shares before the settlement period (delivery date) of the shares actually occurs. If they find it before then, no one is the wiser (except the SEC, when it decides to do anything ever).

Despite what idiots online believe, naked shorting isn’t always illegal (hence the word mostly). In particular, the ban on naked short-selling (Regulation SHO) isn’t because the government thinks you’re a meanie for doing it, but because of its hypothesized connections to the 2008 financial crash (actual data on it is mixed). In general, the belief was that naked short sellers helped destabilize investor confidence in the banks, leading to that fun period best remember by watching The Big Short accompanied by a full handle of Svedka.

Naked shorting, however, is legal by bona-fide market makers, which according to our SEC friends means simply it is done to hedge an option position sold (as part of market making duties, to buy and sell a security at publicly stated prices) rather than for speculation. If you want to read boring legal stuff, here’s a link to Regulation SHO.

Similarly, despite what your favorite rocket-emoji’ing internet guru believes, causing an actual short squeeze is hard, and almost always mostly illegal. The last public short interest (the next one should be released on January 27th, per FINRA reporting) on GME was released on Dec 31st, 2020, with this reported:

That’s a lot of shares.

We can also turn to alternative datasets like Fintel which at least claim (as in I have not validated their data) to track short share availability (per availability at a “leading brokerage” in their own words), which suggests a fairly grim picture for shorts:

I can afford some of those!

That said, take it with a substantial grain of salt — in general it’s incorrect to believe that there are solely 4,000 shares short remaining, and block trades and dark pools (including a rather juicy short interest rate, which makes it likely a ton of longs are participating in allowing shares to be shorted) likely make the available pool much larger.

More interestingly, let’s observe the short interest versus GME’s stock price over the past month (up to 12/31, the last public FINRA report):

Blue is SI, versus that cute parabolic ramp representing share price.

We can see, despite the WSBian rallying calls, apparently those rascal shorts have slightly dug into their position if anything as the stock price ramped up. What happened?

The biggest villain (other than Citron) in the WSB-GME narrative has been thus far Melvin Capital, an investment firm run by Gabriel Plotkin which dared to have a short position in GME. More interestingly, let’s look at the last public filing by Melvin, which reported in Q3 2020 about $20 billion (with a b) AUM (find it here).

As you can plainly observe, the short position here consists of put options, not shares (author note: short positions are not recorded in 13-F filings, specifically to avoid the phenomenon GME is experiencing). Specifically, their put position (which, as of report date 9/30 GME was $10.20) consists of about 54,000 put contracts purchased.

Even assuming the worst case scenario here (let’s assuming somehow the put value was $10 and they held until now and the put is worthless, the max loss is $54 million for a hedge fund with $20 billion AUM, for a max risk of about 0.27%), Melvin Capital is sleeping fine. Because they bought puts, and didn’t short shares directly, their max loss is capped (the premium they paid). In all likelihood (given that they likely sold out much earlier, since last report was 9/30), they lost substantially less than WSB would love to believe.

In all likelihood, the following is probably (not certainly) the case:

1. Most initial short sellers have abandoned their position at some loss — it’s very likely Melvin did take a loss on their position, but not nearly as catastrophic as some erotica writers on the internet want you to believe.
2. Others have averaged in over time — very few short sellers don’t want to take advantage of the current hype, and are likely averaging in to capitalize in the inevitable fall.
3. Most sophisticated short firms have minimal exposure (due to hedging or diversification) — As we can clearly see with Melvin, the GME short position (WSB’s boogeyman) represented at last filing a whopping 0.27% of all assets under management (in actuality almost certainly much less). Firms have defined amounts of risk they’re willing to deal with, and few are losing much sleep over the GME hype beast.

In general, a crafty short seller (a.k.a. most long/short funds) will do the following to ensure the internet doesn’t outsmart them:

1. Capping loss with put options — With a put option, you roughly get all the benefit of shorting a stock (minus the premium paid and strike) with a finite amount to lose.
2. Capping loss with OTM call options — This is my favorite, and one of the more common strategies. When you assemble a short position, you aren’t stupid hopefully — you understand stocks only go up, and infinity is a much farther number from current price than 0 (using a discrete numeraire, of course).

Using either of these strategies, you can keep your risk management team happy, and maximize returns (long/short funds, for example, short various stocks and long others in order to create higher returns).

So if it wasn’t the lovechild of evil Melvin and Citron that created the GME short interest, what did?

2. Option hedging.

Remember that when you buy an option contract, on the other side of the trade (the counterparty) is usually an individual with much better data, much higher tolerance to drawdown, and special rules (the market maker). Unlike you, my dopamine-addicted amigo, the market maker does not like directional risk — whether GME goes up or down, For a put position (or when you sell a call, or any more complicated scenario you can devise) the market maker has to hedge (assuming they were the selling party in the trade) by shorting the underlying, or they are exposed to a large amount of risk. This is where Regulation SHO comes in.

Market makers, unlike hedge funds, are interested in keeping the market functioning and supplying tasty liquidity, and hedge in order to give you that sweet option convexity which feeds the dopamine receptors in your brain. Because of this, the government (the SEC) gives them special rules to allow naked shorting, with the understanding that they can almost always locate the shares before the settlement date. This almost always works because market makers are large institutions (Citadel, Virtu for some common examples) that handle these transactions at scale, and can handle drawdown. You, dear reader, are not going to blow them up. Similarly, because many of them are engaged in beautiful payment-for-order-flow (PFOF), they can actually see and predict the order bombs coming in real time, and adjust pricing (or as you might know it, IV) in real time to account for the predicted price increase and still make a profit.

So, we’ve established the following:

1. Short interest, at least according to FINRA data, did not seem to decrease in relation to GME’s price increase — this doesn’t logically hold in a short squeeze thesis, given equity-based short sellers are sensitive to the underlying (their risk is uncapped, at least in theory, as the underlying price goes up) (author note: as specified in the Addendum, in the initial stages of the squeeze short interest may go up, as new shorts pile in).
2. Melvin and large players held short (at last report for the SEC, 9/30, which is a GME-lifetime ago) using put options — these again have capped risk, assuming these positions have not changed over time. In general, long-short firms would not have massive exposure to GME or get blown up, despite what WSB tends to believe.
3. Put volume, like call volume, has gone up astronomically, leading to more shorted shares by market makers. Unlike the metric Fintel reports (shares available to short) market makers, especially attached to institutional players, are allowed to naked short (and have large amounts of dark liquidity).

Friday’s data, wee.

4. Market makers can hedge exposure by selling/buying options, especially for small moves in the underlying — A put and call position, at equivalent strike/date, has an exposure of 0 delta (assuming no change in the underlying). While this changes as the underlying moves, this implies that a large portion of the implied delta on options sold might be partially or fully hedged by selling other options.

So… it seems the short squeeze thesis might be a dud. So what did happen to GME?

Note: I have no position in $GME and have no intention in the next week to open one.

Addendum: After posting on Twitter, received some very compelling rebuttals to various points from Kris Sidial (https://twitter.com/Ksidiii), Mitchell Rosenthal (https://twitter.com/M1tchRosenthal) and Alex Good (https://twitter.com/goodalexander) about ingredients which might imply it is a short squeeze (or rather, a short squeeze is part of it):

1. 13Fs do not list short positions — This is a point I did consider, but decided not to construct an argument using absent evidence (it’s not able to be proven or disproven). That said, as Alex and Kris noted, it’s quite likely that Melvin Capital may have short positions, given 15% down year-to-date according to WSJ.
2. Short interest can increase in initial stages of a short squeeze — This can be the case because while existing shorts may bail, new shorts may flood in, hoping to speculate on a quick decline. Although as the graph from Ortrex shows, it stayed roughly flat, initial stages of a short squeeze can have increasing short.
3. Brand names attract new short sellers — It’s quite likely initial shorts have closed or averaged into positions, but new short sellers may likely be attracted due to the famous Citron-WSB war. Those may have been blown out during Friday’s ramp up.
4. Short lending rate is important — As noted (at least on Fintel) the short lending rate is increasing, and brokers have limited or outright discontinued margin for GME. This is evidence of growing pressure on shorts, but I’d argue this isn’t necessarily indicative that a short squeeze was the driving factor on the stock’s momentum (from this alone).