Disclaimer: This is not financial advice nor should this be taken as absolute truth on the situation. This is merely my analysis of the current situation.
Starting last week, GameStop (GME) stocks have gone through the roof. There’s been a lot of blaming as to what’s going on, particularly by those claiming market manipulation by brokers like RobinHood. Here’s the situation as I understand it:
- In 2019, GME shares were trading under $3.00 and the company was hunting for its 5th CEO in a little over a year. The company was widely considered a failing retailer, not unlike Blockbuster. Large hedge funds bet that the company would go bankrupt and opened large short positions against it. These bets looked safe for a long time and the percentage of shares that were shorted exploded to over 140%. That means over 140% of available shares were short. This is an impossible amount to cover which means funds that held these short positions believed that GME was truly going to $0.
- In December of 2020, Ryan Cohen invested in GameStop, becoming the majority shareholder. Ryan Cohen previously built Chewy, a website that sells pet products online. PetSmart reportedly paid 3.35 billion for the company in April of 2017. As far as board members go, Ryan Cohen was considered a very strong addition to the team and sparked some confidence in the stock, jumping the price to above $30 per share in the middle of January 2021.
- The retail market began to notice that GME was over shorted and that some people, like Michael Burry (the guy who predicted the 2008 crash) were beginning to make good returns on their investments. This triggered retail investors to pile into the stock last week, pushing the price above $60 per share. There were a number of options contracts open on GME at $60 that all expired in the money at the end of last week. When options are exercised, they have to purchase the stock to fulfill the order, causing the demand to increase even more and pushing the price over $100. Institutional investors start buying GME because they see what’s going on.
- The hedge funds, led by Melvin Capital and Citadel start to incur huge losses. They bet the stock would go to zero but instead, it skyrocketed. This means they’re on the hook for the difference between the stock price and where they set their short position. Melvin Capital loses tens of billions of dollars and Citadel takes huge losses as well.
- As worthless shorts get margin called (when brokers force an option to close because the trading account doesn’t have enough collateral), it forces brokers to purchase stock to fill those shorts. Remember, in order to close an options contract the stock has to be purchased. When there are a lot of short positions and a stock goes up, some shorts are closed by brokers which triggers the price to go higher, causing more shorts to be margin called as well. This is what’s called a short squeeze and what the Reddit users predicted (correctly).
- As losses became total for anyone that was holding short positions on GME (meaning the funds would become insolvent), the system started to break down. On Thursday (January 28th, 2021) RobinHood and many other brokers halted the purchase of GME and several other stocks for retail investors only in what appeared to be market manipulation on behalf of their hedge fund buddies. As explained by the CEO of Webull (another app like RobinHood), the entire system was in danger of collapsing so clearing firms forced brokers to stop selling certain stocks.
- At market open on Friday, GME stock was back above $400 per share briefly before falling back to the $330s. Short positions still have to unwind which will create further upward pressure on the stock when that happens. That’s what Reddit users are currently waiting for.
So, that’s the play by play. Here’s a more in-depth explanation of what’s happening and why this is such a significant event.
There are not enough shares of GME in circulation to satisfy the short positions
This means that when those options are closed out and shares must be purchased, they have to buy at whatever price they can get. This is creating a feedback loop and infinite upward pressure on the stock price.
Hedge funds don’t have the cash or equities to cover these positions. That’s why markets have been down all week despite GME going to the moon – funds have to sell their other equities to cover their GME positions.
When the hedge fund can’t cover their position, the brokerage is on the hook for it. When the broker can’t cover the positions, the clearing firm is on the hook for it. When clearing firms don’t have the liquidity to front the transactions, no money can exchange hands during trades.
Clearing firms are the guys that back the whole operation. Back in the day, you used to ride your horse down to the NYSE and exchange cash for a stock certificate. In a digital age that’s no longer an efficient system so clearing firms now exist to front the capital for when someone buys or sells a stock.
When you buy a stock, the clearing firm is putting up the capital for you because it takes 2 days for your funds to clear into their account. The market can’t work with a 2-day time lag, so clearing firms provide the credit to act in the interim.
GME stock couldn’t be purchased yesterday because clearing firms did not have the capital reserves to fill all the buy orders. At $400 per share, multiplied by the billion shares exchanging hands over the span of a day, the clearing firm would have to have $400 billion in liquid cash to cover those buys because they don’t settle up their balance sheets for 2 days.
This means that the entire stock market almost collapsed yesterday as clearing firms started running out of money.
When a clearing firm runs out of money and you sell your position, there’s no money to hit your bank account. That’s what almost happened.
Once the retail traders were cut off, it looks like hedge funds drove the price into the ground to liquidate some of their exposure to their most aggressive short positions. As GME hit $120 on Thursday, it appears that hedge funds purchased some of the shares to reduce their downside. Retail was blocked during this process making it impossible for normal people to buy the dip. Reports show that hedge funds reduced their exposure by up to $6 billion from this coordinated attack on the stock price. This is unconfirmed but it’s starting to look like this is what happened.
If true, this qualifies as market manipulation and is highly illegal.
The degenerative gambling of Wallstreet has almost reproduced an event on the scale of the 2008 financial crisis. What would have happened to every other security traded on Wallstreet when the entire system shuts down? My guess is that the entire equity market would be liquidated as funds, brokerages, and banks scramble to unwind their mess and stay solvent.
Of course, the government would just bail them out again and you’ll be the one left holding the tab just like 2008. If the entire market unwound as it should, every stock in your retirement account would go to near zero and put every publicly traded company in the US at risk of insolvency.
But make no mistake, we’re firmly in another financial crisis and just like 2008, and just like 13 years ago and no one knew what was going on until people with boxes walked out of Lehman Brothers, no one has any idea of what’s going on now.