It is quite remarkable that GameStop (GME) has become the poster child of the current speculative fervor, one might even call “gamification”, in the stock market. This is not the first time, and not the last time these events have happened or will happen, and a careful look at the environment we are in could help dispel the generally held view this is irrational. One could argue that given the macro environment, level of interest rates, retail trading access, and democratization of derivatives, this outcome might actually be the most optimal collective response to those conditions.
Gamification of the Stock Market is Here!
First, the market has become a self-organized system in which communication between social media participants can move much more rapidly than traditional television and print can. Any asset can become the focus of communication, coordination and execution. Even a mall-based video game retailer, of all things. In the case of GME, it appears to be a self-organized, coordinated “hunt” against short-sellers. Like a locust swarm, this system can devour large objects (see my article in Forbes here from last year’s Kodak experience).
Second, many participants (please see the Reddit “WallStreetBets” [WSB] feed) believe that it is them against the establishment. In the spirit of the times, they believe their coordinated actions are justified from a basic social equality point of view and they express this solidarity by urging others to hold their profitable longs and not to sell. They have found heroes, like Elon Musk, in this endeavor. These heroes have credibility, deep pockets and have shown that they can succeed by challenging the establishment. Nothing encourages religious behavior like having an icon who has overcome massive challenges. When it has an undertone of a crusade against increasing inequality, market vigilantism is often the natural outcome.
Third, by using short-dated call options on stocks with limited liquidity, the “bros” have isolated very efficiently, without much formal training (but lots of street smarts), the key elements of what a call option provides: leverage, upside asymmetry, exposure to jump risk, and exposure to volatility. If a cheap stock is a call option on the underlying firm, then the actual call option on the stock price is a compound call option – a massively levered bet. I wrote a paper on this mispricing phenomenon when melt-ups are possible in the Journal of Portfolio Management a couple of years ago, but certainly had no idea how important the concept would become in real life in such a short time.
Fourth, macro-economic policy has never been more supportive of this leverage enhancing strategy and now handcuffed. The Fed, ECB, BOJ are printing money, and the US government is sending checks in the mail to support the speculation. They are trapped because they cannot even hint at more regulation or tighter policy for the risk of killing the broader stock market.
Fifth, underlying valuation seemingly means nothing. Before we jump into making a judgment on retail investors buying call options on companies that might not survive, we have to note that when bond yields and interest rates are negative on almost thirty trillion dollars’ worth of global bonds, valuation means little in most markets today. This valuation debacle is a natural consequence of economic dogma gone hyperbolic with turbo-charged money printing. So don’t blame retail for being valuation ignoramuses.
Thus, we can see that the coordinated strategy of the Reddit WSB group, at least in the short run, has been almost optimally executed, perhaps accidentally given the environmental conditions. It has limited risk, it is massively levered, orchestrated via real time communication, and has a religious flavor to it. The participants have collectively turned out to be more rational in the current environment than academic theory or Wall Street pundits give them credit for, especially if rationality in the financial markets can be equated with profits.
So how should investors deal with it going forward?
First, unless you have a long enough holding horizon, it’s best to just stay out of this game, and a game it is. This specific game may stop (excuse the pun), but others will take its place. For most people this should be no more than entertainment to watch in the time of COVID-19 lockdown, a break from Netflix binging.
If one has a strong view, capital and the holding power, an investor can try to sell a small, diversified basket of the call options that the retail market is buying, as long as one doesn’t get forced out or forced to hedge. The timing and future evolution of this strategy is unpredictable. At Black-Scholes implied volatilities of close to 1,000% on the shortest expiry options, there is no formula that is even remotely close to providing the “greeks” for hedging. This is un-hedgeable, and a trade, if you want to call it that, that is almost all psychology. Do not rely on any quant analysis or textbook theory that suggests otherwise. Once the dust is settled, there will be, like there are always, folks who claim they knew and forecast the ending.
Which brings us to the natural cycle of evolution of this glorified game. If you are a video game follower, in multi-player games the game never ends, it just moves from one venue to another. The fun is the process itself. It will just move to other names and tickers. Insiders of the companies who have seen their stock go up hundred fold in a matter of months, who have now seen their holdings become worth billions, may monetize, or authorize issuance of more stock, or split the stock price to encourage even more participation, or there will be a break in the coordination and someone will decide to exit. This has the potential of starting a cascade if they hold a consequential amount of stock. Or, which is more unpredictable, some sort of regulatory action or a stop on the trading of options or the stock itself leaves the latecomers holding the bag. This could result in trapped longs who may not be able to monetize all their paper gains in time. Or brokers might gang up and refuse to execute retail call option trades in the short term, eventually succumbing to the temptation of transactions and churning trades for the next level in the game.
Personally, I would not bet on any of these possibilities with too much of my own capital. In a world of massive central bank created distortions, democratization of trading via online platforms, and a need for entertainment and volatility for a crowd of trapped people, anything can happen.