Why Gamestop went to the moon with Gamma Squeeze

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Some Background

Gamestop (GME) is a dying videogame store with more than 5,000 stores. The company couldn’t keep up with digitalization as major platforms such as Nintendo, Xbox, and Playstation starts to sell their products digitally. Skipping offline distributors such as GME.

Ryan Cohen and Michael Burry took a sizable stake and joined the board of directors and attempted to turn the company around.

On the other side, GME is heavily shorted with a 150% short interest. One of GameStop’s short sellers is Melvin Capital.

In this case, Melvin is betting on GME price falling and sold GME shares without owning it. He did this by borrowing GME from his broker.

The risk for Melvin is ‘unlimited’, if GME goes to the moon, he will have to buy back at exorbitant prices and return it to his broker.

This all changed when WallStreetBets (WSB) ‘retards’ (they refer to themselves as retards, degens, etc) decided to pull off a french revolution of finance and do a short squeeze on the short-sellers (i.e. mainly hedge funds):

The Short Squeeze

A short squeeze happens when a heavily-shorted stock experiences a price rally.

When this happens, short-sellers such as Melvin Capital would have to cover their short positions. They would be required to buy GME (at any price) and return it to the broker. Further propelling the upward price movement.

Short-sellers are squeezed out of the market. The biggest casualty of this squeeze was Melvin Capital, a hedge fund that started the year with $12.5 billion in AUM and lost almost 30% through Friday last week.

It announced an emergency infusion of $2.75 billion from fellow hedge funds Citadel and Point72 on 25 Jan 2021 and told CNBC today that it closed out its short position in GameStop on Tuesday afternoon.

The Gamma Squeeze

A gamma squeeze happens when the world of options meets the stock market.

For example, when you buy a call option on GME at a strike price of $60, you have the right to buy GME at $60 anytime before expiry.

The person who sold you the call option will have the responsibility to sell you at $60 if you decide to exercise your option.

To protect against this risk, the seller will buy some of GME stock, in case you exercise your option and they have the responsibility to sell it to you at $60. Even if GME went to $300, they will have to sell at $60.

The amount of stock they buy for protection is based on the delta—how much the option price moves in relation to a $1 move in GME stock price.

Gamma is simply the rate of change of the Delta of the option.

When Delta and Gamma rise, the seller of the call option will have to buy more GME stock to protect their position!

When GME stock price starts to increase, sellers of call options had to buy a lot of GME stock to protect their position.

Self-fulfilling prophecy

Both the short squeeze and gamma squeeze set in motion a self-fulfilling prophecy. As both short-sellers and sellers of call options start buying a lot of GME to cover their positions. Propelling the price upwards.

Envy is the worst sin

Disclosure, I have not participated in this rally even though it has been rather entertaining.

The stock market and options market could a tool for adopting a business owner mindset or a speculative mindset. It’s easy to cross the line and I’ve made a rule to stay in the former.

Nothing wrong with a bit of speculation. Just a personal rule.

I would like to end off with a Munger’s quote:

If you have found this useful, please share it with your friends! It would encourage me to share more about what I learned on options :)

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