Can someone explain the GME short squeeze situation to a non-stock trader?

Question

GameStop Corp. (GME) stock is over $300 at the time of this post. I understand the 10,000 foot view of the story only: That some Reddit folks are buying up shares to squeeze a short seller.

But I don't understand how this works. Why buy shares? Aren't they stuck with them when the bubble bursts? Seems like many of these people will be stuck holding shares when they come crashing back down.

I also saw a report of one Redditor who turned $50,000 into $22,000,000 using options of GME. Though this may be a separate question - how?

Answer 1

You're a non-trader. So you maybe don't even 'get' what short-selling is intuitively yet. Let alone options. I'll try to make this as simple as possible.

Stocks first, options later:

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Let's pretend we're not trading stocks, we're trading the latest Playstation 5 (seems appropriate).

If you think the price is going up then you buy a PS5 today, hold onto it, and hopefully sell it for a higher price in a few months.

If you think the price is going down, then you short-sell a PS5. Which goes like this:

You find a mate who already has a PS5. He's not really playing it right now. So he offers to lend it to you for £5 a week, as long as he can have it back as soon as he decides he doesn't want to lend it out anymore.

You sell the PS5 today for £500. And hope that it drops in value fast enough that when you have to buy it back, you'll have made a profit on the whole thing.

The key elements are that you have to borrow it from somebody who already has one, you have to pay them something (usually it's interest, not a fixed charge), and you have to buy it back later, sometimes without any say in when that happens. (Unlike with your actual mates, brokers and clearing houses aren't going to give you any leeway when they need to recall the shares).

Now if you sell too many like this, you might not be able to find enough to buy back when the time comes, and will be forced to pay whatever it takes to get them.

If somebody (In this case, people on reddit) notices that you've sold all these Playstations you don't have, they might decide to buy them all up first, to make sure that there are none left for you, and you have to pay an exorbitant price to buy them back.

This is a classic short squeeze. And usually you'll end up buying the Playstations back for 50%, 100%, 200% more than you sold them for just to get out of the trade.

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That's bad enough. But now enter options:

Today, we're just going to talk about call options. A call option looks like this:

I pay you some amount of money for the option. In return, you promise to sell me 1,000 Playstations, for £2,000 each, at any point in the next 3 months, if I decide I want to buy them. (I have the option of buying them at a fixed price. Hence the name).

Back when Playstations were going for only £500 each, hedge funds would happily sell you that option for almost nothing, because there's no way the price is going to go that high in the next 3 months, so it's basically free money to them.

But then here's what happens:

They sell you a huge pile of options. In fact, they sell you options for half of all the Playstations in the world. Because there's no way they'll ever have to actually deliver them.

Then you start squeezing the stock. The price goes from £500 to £750. The hedge funds start getting a little nervous. £2,000 is still a long way away, but the price is already higher than they thought it would ever go. So they buy some Playstations just in case.

But buying more Playstations pushes up the price even further. Suddenly they're at £1,000 each. The hedge funds and the short sellers are starting to sweat a little. They buy more Playstations.

The price is pushed up even more. So they panic even more. And buy even more. If there's enough people buying because they sold the shares short. And enough people buying because they sold options they never thought would ever have to be fulfilled. And not enough Playstations to go around because the guys on the other end of this trade already bought them all, and all the options, and are holding them ransom.

Then there's nothing stopping the price going to infinity. (Or in this case, going up 2,000% and counting). *

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The people who sold the options. When they buy a little bit to hedge. And then start buying more and more as the price gets closer to the point where they're on the hook. That whole thing is called Delta Hedging, and the amount they buy as the price changes is called Gamma (and hence this situation would be called a gamma squeeze). It's just "buying more of the thing you're on the hook for, the more likely it is that you'll actually have to deliver it".

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Now to answer your questions:

Yes, if you buy the shares. And keep holding out for a higher price. You might miss the window as the whole thing comes crashing down again. Because it will crash eventually. Options will expire. People will decide to cash in and relieve the pressure. At a certain point, often quite suddenly, the whole thing will go into reverse and it'll be the people holding the options and stockpiling the Playstations who are desperate to dump them before the price crashes even further. Maybe you're the guy who buys the shares at $20 and sells them at $60. Maybe you're the guy who buys them at $60 and sells them at $300. And maybe you're the guy who buys them at $300 and sees them crash to $100 only an hour later. **

As for the $50,000. That was a guy who bought those options for pennies on the dollar. Basically the funds went "Yeah, sure, Playstations at £2,000 each within 3 months. Never gonna happen. We'll offer you 200:1 odds on that". He bought them, it happened, and now he can cash it in for a massive payout.

The way that actually works is that the option is for 1,000 Playsations at £2,000 each. And they sell the option to you for £2,500 total (£2.50 per potential Playstation). So you buy 20 options for £50k.

They're worthless if the price is less than £2,000. But if the price is now £3,000 per Playstation (IE your £2.50 per console is now worth a cool £1,000 per console). Then they're worth 1,000 Playstations * £1000 * 20 options = £20 Million, for a 400x return.

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* There are, actually, lots of things that will eventually stop it going to infinity. If not people selling of their own accord, then brokers or regulators will eventually step in and put a halt to things. In this case, brokers just stopped most retail traders from being allowed to buy new shares/options, which stops the squeeze and starts the rush to the exits.

** Like, say, today. 28th January 2021. Where GME opened at £263 per share. Almost doubled in the space of 30 minutes to £469 per share and in the 90 minutes since has dropped 75%.

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If you enjoy entertaining and informative explanations of what the hell is going on in finance today, you should read everything Matt Levine has ever published. Including the last 4 days' coverage of GameStop.

Answer 2

Short sellers borrow shares that they believe will drop in price in order to buy them back after they fall. If they're wrong, they're forced to buy at a higher price, incurring a loss.

More than 100% of GME stock was shorted by traders and investment funds. Redditors drove the price up, forcing these shorters to buy the stock to cover their losses.

Another factor in this is what's called a gamma squeeze. When traders buy options, if the counter party is a market maker, the market maker offsets the risk by taking a position in the stock. Redditors have been buying large numbers of calls.

As an example, an at-the-money call has a delta of about 0.50. So for every ATM call that the market maker sells, he buys 50 shares to hedge the delta risk.

Gamma is the rate of change of the Delta. As the stock begins to rise, the market maker needs to buy more shares as delta and gamma rise. This adds fuel to the short squeeze fire.

Now as share price continues to rise, many shorters cover their short positions. That means more buying of the stock, further increasing prices.

A good description of all of the combination of all of these factors would be a chain reaction where share price literally blows up.

As for getting stuck with shares, that happens to everyone in the market who owns stock when the stock drops (see last March when the market dropped 35%). GME has gone from about $20 to over $350 in a couple of weeks. That's not a bad problem to have if you bought early and it is easily fixed. However, you could become a bag holder if you bought near the top. Yesterday the top was around $160. Today, so far it's been around $352. But when will the top finally occur? Today? Tomorrow? Even later?

Answer 3

One interesting aspect to this situation that I think is under-discussed is

• Why don't the shorts just wait for the squeeze to end?

After all, GME is practically worthless; in 2022, the value of GME is more likely to be 10$ than 100$. If you have shorted GME and you just wait until 2022 to give it back, you won't be out any money at all.

Unfortunately for you, shorts can closed out at any time by the lender. So rather than thinking of a short as being a bet that a stock will go down in the future, you must think of a short as being a bet that a stock will never increase above its current price before you decide to buy it back. Because if it did increase, the lender could demand it back immediately, and regardless of its long-term prospects, you lose money.

A put is a similar investment with a fixed time horizon that avoids this risk, but of course has its own disadvantages.

Answer 4

This is one of those things that comes around sometimes in the market and is the number 1 risk of shorting stocks - a short squeeze.

To recap really quick as others have already stated, shorting a stock is where you borrow it from someone else, sell it in the market and then hope to buy it back at a lower price later thus making profit: Borrow at 10, sell at 10, price goes down to 5, you buy it back in the market and return it to where your borrowed from. Profit 5. The questions here are usually why would someone lend you a stock you knowing you are trying to make it go down? Well, big investors like pension funds will hold a stock for years if it is in their index so they're happy to make a bit of extra money lending it out to you.

The biggest risk of shorting a stock is that the price goes up by so much that your broker asks you to post more collateral in your account (a margin call). If you can't or won't, then you have to buy it back in the market at a loss. This buying then adds to the upwards pressure on the stock, pushing the price higher.

In the short term, stock returns are all about supply and demand. If i don't want to sell and you really want to buy then i can ask for a higher price for the stock. In a short squeeze, lots of people that had borrowed shares now have to go and buy them back in the market at the same time thus increasing demand and pushing the price of the shares up.

A good primer into what happened with GME is back in 2009 when VW was being heavily shorted when its biggest shareholder, Porsche, announced to the market that it actually owned many more shares than it had previously reported. This meant that the number of shares being borrowed (the short interest) was more than the number of shares available (this is important). Essentially, supply completely dried up and brokers demanded more money on margin accounts which pushed the price of VW up dramatically to where for about 15 minutes VW was the largest company in the world by market cap!

On to GME. GME has for quite some time been a favorite of short sellers that have been expecting it to go bankrupt due to it being a brick and mortar retailer. A guy on reddit, for the past year has been trying to highlight to people on r/Wallstreebets that the short interest was so high that the company was susceptible to a short squeeze. Last week, he finally saw an opening.

He saw that the January call option expiry was coming up and the Gamma was very low, Gamma being a measure of an options volatility and essential to the calculations that brokers/market makers use to calculate how many shares they have to have on hand to cover the option's collateral. His argument was that if everyone bought these call options then it would require the market makes to go out and buy more shares, the slight rise in share price that would accompany this (and normally nothing to worry about) would mean that more shares would need to be bought as the low gamma would increase thus creating a kind of multiplying effect and a feedback loop. The more the people bought the calls, the more shares the market makers would need to buy, the higher the gamma would go, the more shares the market makers would need to buy and so on.

In normal conditions, a deep liquid market would have no problem absorbing this buying and your OTM calls would expire worthless, losing you money. However, as around 160% of the total shares were committed to being lent out to short sellers this was not a deep and liquid market. He got the feedback loop he wanted and a mega short squeeze. Once others saw what was happening they jumped on the bandwagon, pushing the price up to crazy levels.

As to your two specific questions:

Will people get left holding the bag? Yes. Always the case as shares are zero sum. Now, are these new people coming in or the original people that started it? Who knows.

How did one guy make 22m from 15k? Out of the money (OTM) options. They have a huge amount of leverage in them as they allow you to buy a large number of shares for pennies on the dollar at a fixed price, especially as they were due to expire in a few days.

Answer 5

Simply put: short sellers are betting a lot of money against the stock. If they lose that bet, someone has to win - the money has to go somewhere. As they cannot hold the bet forever, it is possible (not necessary!) that they lose.

If they lose, someone else has to win. If they lose big, someone else wins big.

In reality, a lot of people will lose big and a lot of people will win big.

Answer 6

Gamestop was shorted to over 130% of its shares. As the price rises the hedge funds who hold the short interest must at some stage settle their position. This means they have to buy 1 share for every share they have shorted. As the price rises the cost of them exiting their position rises exponentially. As there are few shares available the demand far exceeds the supply. The price MUST go up. This is the squeeze. In theory it can go to infinity. At some stage shareholders will cash in and the share price will crash. This is clearly understood, but one of the aims is go give pain to the hedge funds. It will result in a significant redistribrution of wealth from hedge funds to retail investors. Many shareholders are prepared to lose 100% in order to punish the large hedge funds (seen as the elite Wall Street suits)