Equity markets can be a fickle beast at times. In a perfectly market efficient world, stock prices would only move when significant fundamental information regarding the future prospects of the underlying company and moves would be inline with the associated changes to intrinsic value.
However, other than the Mona Lisa, things in life tend not to be perfect. In the context of financial markets, this means that share prices can be driven by a multitude of factors of which include; rampant speculation, mania, momentum and a rafter of other causation factors.
As we all know, bubbles are delicate instruments and only require the slightest friction before there imminent demise.
Throughout the history of financial markets periods of extreme over exuberance are followed by a painful (and often over enthusiastic) sell off. Typical of these events every investor who exhibits extreme confidence in the future, became pessimists of the highest magnitude.
Today we are seeing this over enthusiastic behaviour compounded by the use of leverage, internet chat rooms (like Wall Street Bets) and pure speculative mania. The recent run up of the share price of Game Stock is the epitome of this behaviour. A stock, heavily shorted due to it's fundamentally flawed business has risen from recent lows of $4 to over $300 to the chagrin of those short the stock, resulting in the impending collapse of Melville Capital.
In a move that would impress the Occupy Wall Street movement of last decade, an army of Reddit option traders have managed to bring down a $13,000,000,000 hedge fund in mere weeks. This has move driven by a multitude unique factors also.
To understand what is happening here, I need to first explain how short selling works. If you have seen The Big Short, you might already have some idea, however let me give you a little refresher.
Pretend you own two cows each worth $100. You don't do anything with them, they just sit in your back paddock. I think cows are going to be worth $50 so I pop over the fence and ask to borrow your cows. You don't want to just let me borrow them for free, so you charge me a fee. This is called paying the borrow cost.
Once I have bought your two cows, I go off to the market and sell them, giving me $200 but I owe you two cows. In the future the price of cows drop to $50 each, so I again go to the market, except this time I buy two cows and return them to you. My profit would be $100 minus the borrow cost I pay you. Pretty simple right?
What if the price of cows goes up? In this case the price of cows goes up to $150 each. I would have to go to the market, buy 2 cows for $300 and then give the two cows back to you. Except in this case I lose $100 plus the cost of borrowing your cows.
This is how short selling works in it's most simple form. Sounds like a great way to make money. Just normal investing of buy low, sell high in reverse.
However, they are some extra risk factors that require attention. I am only borrowing your cows, if you call me up and demand your cows back I have to return them. I will have to sell in order to pay you back, the price of cows is irrelevant.
Even more concerning is that there is unlimited downside risk. If you own the cows, the worst that could happen is they go to $0 and you lose $200. However, it is was to come out that having a cow in your background will give you the ability to fly, the price of cows would sky rocket. I might be forced to pay $1,000 a cow to return them. As prices could in theory, go to infinity the maximum I can lose is infinite.
In the real world, we rely on third parties like stock clearing house, brokers and custodians to ensure that the market moves smoothly. One of their responsibilities is to ensure that if you are short stock, that you have the ability to pay for the stocks in the market. When prices go against short sellers, they need to put up more money as collateral to keep their positions. Not enough money, means the broker will close your position on you to prevent further loses.
Again working in reverse is what happens what the positions moves. If you own a stock and it goes up, it becomes a bigger percentage of your portfolio, if it goes down it becomes a smaller percentage.
When you are short the opposite occurs. Using our cows example, say you have $1,000 and decide to short one cow for $100. In your portfolio you would have 10% cow, 90% cash. Let's say cow prices double to $200. You would know have a portfolio of $200 cow, $800 cash (because you had to put more cash in as collateral) and your percentages are 20% Cow, 80% cash.
What we have seen with Gamespot in the US, can be described as this. A huge hedge fund was short Gamespot (GME) stock. In fact, there were more people short GME, than shares available (this is very important). Now, the Reddit forum, Wall Street Bets (a very popular investing forum which is famous for people taking outlandish and borderline ridiculous bets on stocks) have started buying huge amounts of stock and call options on GME.
I won't bore you too much with out stock options work, but effectively buying a call options gives you the ability to purchase a stock in the future at a predetermined price. In cows, this means I pay you a deposit (called a premium) for the right to buy a cow from you in the future at $150. I do this because I might think the price of cows are going to go up a lot or maybe because I don't want to take the risk of a cow going to $0. The most I can lose is the premium I pay. Let's call it $5.
If the price of cows are above $150, I would use this option and it is below, I would let it expire worthless because why would I pay $150 for a cow if the market price is $100??
Options use a large amount of leverage, it helps that the initial premium can be cheap (typically sold in 100 share units). Market makers (the ones who help the trade go between buyer and sell, almost the real estate agents of the stock market), will typically look to minimise their risk, so when people buy large amounts of options they will buy the underlying stock (or cows in my example), to prevent them losing money.
The combination of a very shorted stock, an army of Reddit traders that are buying huge amounts of call options, market makers buying and the constant media coverage has resulted in the stock skyrocketing upward. And the hedge funds that have shorted the stock are losing money hand over fist and being required to post more money as collateral. Once you run out of money, you might have to sell other assets to meet the margin calls or be closed out of the position. However, the owners of the stock are refusing to sell driving prices ever higher again.
This got to the point last night that many brokers such as Robinhood and Interactive Brokers did not allow clients to buy stock or options on GME.
Now, this is obviously not normal market behaviour and it is almost certainly going to delate, however the when, where, why are all a mystery to me at this point. Rather then get caught up in the speculation, I am going to simply continue to do what I have always done, which is to manage your investments as per the principles of my last email.
At the current moment it appears that sections of the investing public (I’m including professional investors alongside the Wall Street Bets crowd) are not only forgetting these principles above but are openly disregarding them as being out of date. This is egregious to think that this is going to work over the long term, but in the short term it is critical to remember that markets can remain irrational longer than we can remain solvent so we must be prudent in our judgement regarding the investment of our capital.
As always, feel free to reach out and until next time,
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