By Sam Richardson, BSc Financial Mathematics and Statistics Student at LSE
GameStop has been the centre of retail fuelled investing so far this year, with Fidelity reporting GME to be the most traded stock on their platform as of 24/03/2021. The unprecedented volatility of GME since 2021 has led to several questions about the legitimacy of retail traders, but more importantly, does GME have any more fuel left in its rocket?
To go over this, we need to look at a variety of data from regulatory changes to stock data to understand what exactly is going on with this retro brand and where it could be heading.
To begin with, GameStop has been a struggling company for many years now. Its old-fashioned style of selling games via physical stores has been outcompeted for a long time by large rival companies such as Walmart, Target and Amazon. GameStop’s revenue has declined by 11.6% per year on average and its EPS has been negative since 2019. It was clear that the firm would go under after the closure of 462 stores in 2020. However, in September 2020, former CEO of Chewy, Ryan Cohen disclosed his 10% stake in GameStop (amended to be 12.9% in December) making Ryan Cohen the biggest individual investor of GameStop. From a value point of view, this certainly raised hopes of saving GameStop from bankruptcy as Ryan Cohen transformed Chewy into a successful e-commerce business. So it is likely he would attempt the same with GameStop; this positivity was shown in GME rising 146.27% from September to December.
Whilst Ryan Cohen could bring major changes to the company, in their recent 10-K filing, GameStop highlighted that the risk of reducing prices and increasing spending to compete with their biggest rivals in the market would adversely affect their profitability. This could be one of GameStop’s biggest challenges as Amazon continues its aggressive global expansion; this pandemic has only boosted returns for Amazon whilst disrupting GameStop’s logistic capability. Even as we approach the end of national lockdowns, GameStop faces several issues from paying off long term debt, a rise in the corporate tax rate to 35% (as proposed by U.S. Senator Bernie Sanders) and rising interest rates.
From a market perspective, Jefferies has raised GameStop’s price target from $15 to $175 per share as the recent earnings report showed 34% of their Q4 earnings to be e-commerce, showing the transition to a digital company has already begun and GameStop will continue to close stores as part of this process. Furthermore, the resignation of CFO Jim Bell was led by Ryan Cohen as part of his vision in transforming the company to e-commerce, GameStop went on to state they would look for a new CFO with the qualifications and the ability to accelerate GameStop’s transformation, implying that Jim Bell was not suited to the task.
Overall, we can see how GameStop is changing in order to better rival its competitors in the new digital market, whilst good news, this provides little explanation for the stock price explosion in January and again in March.
Stock Data Analysis
GME has seen exponential growth in 2021; the biggest discussion right now is what type of squeezes have occurred and what is yet to occur. Some argue that a short squeeze already took place in January while others argue it was a ‘gamma squeeze’.
Gamma Squeeze – Market makers need to purchase shares as a hedging strategy against writing a call option, as the stock rises, market makers need to buy more shares to remain delta neutral, thus pushing the price higher.
Delta Neutral – When the overall position of an options trade has a delta of zero, meaning a change in the underlying asset will not change the value of the option.
On January 22nd, GME closed at $65 which exceeded the highest of call strikes ($60) and thanks to these calls being extremely cheap and were OTM until retail investors purchased a lot of GME call options at this strike. Market makers were caught by surprise and were forced to quickly hedge themselves against writing these call options; due to the large quantity of OTM calls now becoming ITM and being exercised, this initiated a gamma squeeze.
Based on this chart, we can see the incredibly large volumes in buying GME on 22/01 as many of these call options expired, so essentially to look for a gamma squeeze we need: large volumes of OTM calls, an unprecedented rise in stock price and preferably low premiums for the call options.
Of course, the uptrend didn’t stop here, GME carried on with strong momentum into the next week to reach an all-time high of $486.00. Now we know retail investors bought GME to exploit the high short interest which was 144% at the time, implying that short-sellers needed to buy more shares than what currently existed in the float. This momentum was quickly halted on January 28th and 29th when popular online broker Robinhood temporarily froze the ability for users to purchase GME, but only given the option to sell. On these days, GME saw the highest volatility it had ever seen with a day range of $197.00-$486.00 and closing at $197.44 from $279.00 on 28/01.
What is interesting to highlight is the sharp decline in volume traded on those days whilst having the highest volatility, showing that GME was cornered to a minority of sellers who could drop the price significantly due to low volume.
This leaves us with the question: did the short squeeze occur?
The Financial Industry Regulatory Authority (FINRA) reported the short interest of a stock twice a month, currently, the short percentage of the float is 44.60% (as of 14/03) indicating that the short squeeze occurred in January and that there is no catalyst for a squeeze to take place. However, in late February, the stock finally rose again to a peak of $184.21. Despite no announcements from GameStop, only a sudden large volume of shares bought. GME had been resting at the 40-50 range for several weeks, which for many it meant the hype was over, though this stock price change suggested otherwise.
As for the option chain, there are 51,524 call options which are currently OTM for April 1st. This volume is not as large as it was in late January and market makers are unlikely to be surprised by another price explosion, so the chances of a gamma squeeze are unlikely. Especially now, these options have much higher premiums, thanks to the volatility of GME, its current stock price is much higher compared to itself in early January. Hence, such a price change could either be due to a potential short squeeze, or the company’s prospects are improving and GameStop could actually make a comeback under new management. Given the stock rose 100.93% on 23/02 in the after-hours market, it would seem odd to suggest this was due to the fundamentals of a company; rather it was an institutional buyer taking a large stake in anticipation of a short squeeze. This raises the question: did a short squeeze occur in late January?
As stated earlier, the short % of float sits at 44.60% (as of 14/03) which is a huge decline in the number of shares shorted from late January, which implies that the short sellers closed their positions and took the losses; after all, one major short seller, Melvin Capital reported a loss of $4.5 billion. However, it is possible that short-sellers created ‘synthetic longs’ as part of a hedging strategy when writing call options, synthetic longs effectively act like a normal share. They are synthetic as they are made from shorting a put and buying a call at the same strike price.
Diagram of ‘Synthetic long’ payoff
So, when a short seller purchases these synthetic stocks, they can write it off as closing short positions as that also means buying the stock, thus a reduction in short % of float. Short sellers could continue to do this indefinitely as the cost of closing the real shorts far outweighs the cost of replicating this strategy. However, any derivative has an expiration date so at some point these synthetic stocks will disappear, which would cause the short % of float to jump back up. It is unlikely that we would see this on paper, as FINRA only reports this data twice a month which gives particular short-sellers time to create more synthetics if needed.
The SEC does state that a high number of ‘fail to deliver’s (FTDs) doesn’t always indicate abusive short selling or naked short selling as FTDs can be genuine, as members of a transaction can fail to deliver on the settlement of a trade. Although, it is possible that short sellers flooded the market with FTDs to force down the price of the stock as much as they could in order to buy back the stocks at a much lower price. Bear in mind, some of these FTDs could also come from genuine failure to deliver call options since such large quantities of OTM calls became ITM which would’ve taken market makers by surprise.
There is evidence to suggest another short squeeze is possible, in the recent 10-K filing from GameStop they stated the risk to their equity holders due to the high volatility of GameStop’s common stock and a possible short squeeze. To quote the company “A large proportion of our Class A Common Stock has been and may continue to be traded by short-sellers which may increase the likelihood that our Class A Common Stock will be the target of a short squeeze”. Now obviously GameStop has to list this as a potential risk or it could face being sued, but nonetheless, there is still the possibility of a short squeeze. Back in 2011, Porsche Group faced lawsuits after the VW squeeze in 2008 and since GameStop is trying to remove its current financial burdens, they would not want any legal costs either. On the other hand, GameStop could want a much larger squeeze to occur since it would allow the company to raise capital via selling shares at such high prices, capital which could be reinvested in GameStop’s transition.
Recently, there have been several changes in rules regarding the DTCC and NSCC. These changes are intended to provide transparency and liquidity to these organisations if needed. Firstly, the NSCC proposed an amendment to change the way they calculate Supplementary Liquidity Deposits (SLDs) such that instead of being calculated once a month; it is every business day. To quote ‘By allowing NSCC to calculate and collect SLD daily, NSCC would be able to identify these exposures based on Members’ daily activity rather than estimate its upcoming liquidity exposures based on activity observed over a lookback period. The proposal would help NSCC mitigate its liquidity risks through the daily collection of SLD from those Members’ whose daily activity would, in the event of the Member’s default, create a potential liquidity need that is in excess of NSCC’s available qualifying liquid resources.’ – Form 19b-4 from NSCC to SEC. Granted, 2021 has seen quite a lot of volatility in several markets but we have seen similar market volatility before but only now is this amendment proposed.
In addition, the DTCC changed how frequently hedge funds need to report their positions; it used to be on a monthly basis but now the DTCC can require a hedge fund to submit their positions at a moment’s notice.
‘Participants must immediately report to DTC any discrepancy between their activity and positions with the information, reports and statements provided by DTC or other issues relating to the accuracy of the information, reports and statements provided by DTC.’ - SECURITIES AND EXCHANGE COMMISSION (Release No. 34-91336; File No. SR-DTC-2021-003)
These changes could indicate that these organisations are preparing to protect the market in the event of another squeeze of any kind. Of course, with the use of synthetic longs, FTDs etc it would seem that a short squeeze could be delayed indefinitely unless regulators decided to get involved. However, GameStop has an Annual General Meeting which normally takes place in June. In these meetings, they could recall any borrowed shares which would force short-sellers to cover their positions.
Combining regulatory changes with the stock data could imply that a short squeeze is yet to occur and if such an event happened, this could trigger a gamma squeeze automatically. Of course, this depends on the price that GME hits in a short squeeze which is quite difficult to forecast. Strategies like FTDs and synthetic stocks could be used in delaying the event of a short squeeze so if all the other data holds, it is a matter of patience.
This is not financial advice only my personal opinion.
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