The GameStop Saga
A short explanation of the underlying mechanics of $GME's insane rise
The story of the week is clearly how a group of retail traders at Wall Street Bets, with assists from Elon Musk and Chamath, took down the establishment short sellers at GameStop.
A short thread on the underlying mechanics of the GameStop saga...
First, for those unfamiliar with the business, GameStop is a videogame and merchandise retailer.
It has >5,000 stores, primarily in malls, across North America, Europe, and Australia.
The business has struggled to modernize, hurting its financial and stock performance.
For a variety of business reasons, a bull (i.e. optimistic) case regarding its future performance has formed.
It really came to the forefront after RC Ventures, an entity managed by Chewy.com founder Ryan Cohen, disclosed a large position and assumed three board seats.
Ryan Cohen summarized his case, stating:
"We are excited to bring our customer-obsessed mindset and technology experience to GameStop and its strategic assets...expanding the ways in which it delights customers and by becoming the ultimate destination for gamers."
At the time of that statement on January 11, $GME stock was trading at about ~$20 per share.
Since then, the stock has surged to ~$300+ per share and captured the public imagination.
How did that happen?
There are two dynamics at play: a short squeeze and a gamma squeeze.
First, a short squeeze.
This occurs when short sellers (those betting against a stock, like Melvin Capital here), are forced to buy stock to exit/cover their shorts.
I wrote a primer on the short squeeze, which you can find below.
The gamma squeeze is a bit more complicated.
As usual, let's simplify it here for everyone to understand.
A gamma squeeze is all about options contracts and their indirect impact on the underlying stock.
For a primer on options, see my thread below.
When you buy a call option on $GME, someone has to sell you that option contract.
You pay them a bit of money (the premium) and they make a commitment to deliver you the underlying stock at a future date for the strike price of the option.
It's a pretty simple transaction.
But in the background, the seller (often called a "market maker") has to think about their risk exposure.
If $GME rises above your strike price, they will have to buy the stock at the market price and sell it to you for the strike price, incurring a (potentially large!) loss.
To hedge this risk, when the market maker sells you the option, she also goes into the market and buys a bit of the underlying stock.
The amount of stock she buys is based on the "Delta" - a ratio of how much the option price moves relative to a $1 move in the underlying stock.
"Gamma" is the rate of change of the "Delta" of the option.
As Delta and Gamma rise, the market maker gets more and more nervous!
She has to buy more stock to hedge the risk of the option being exercised in the money (i.e. with the underlying price above the strike price).
So here we have the (simplified!) makings of the gamma squeeze.
As call option purchasing volumes suddenly surged (thanks to WSB, Elon Musk, and Chamath), market makers had to purchase a lot of $GME stock to hedge.
This set in motion a self-fulfilling prophecy…
As the market makers rushed to purchase $GME stock to hedge their exposure, this drove the price of $GME up.
As the price of $GME went up, the Delta and Gamma of $GME call options rose.
This meant market makers had to buy more stock, further driving up the $GME price!
So to summarize: With $GME, we had both (1) a short squeeze - short-sellers frantically buying the stock to close/cover their shorts and (2) a gamma squeeze - call option market makers frantically buying the stock to hedge their exposure.
Result:
As always, I hope this thread was helpful and makes you feel more well-informed on what is happening in the crazy world of finance.
For more on this topic, I highly recommend reading Matt Levine’s "Money Stuff" newsletter on the topic.
In addition, my friend Shaan Puri wrote an incredible/hilarious thread on the story dynamics behind the @wallstreetbets $GME moves. Check it out here!
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Until next time, stay curious, friends!