Investment Management

Understanding the Gamestop (GME) Short Squeeze

The Gamestop (GME) Saga

The speed and magnitude of the increase in the price of shares of Gamestop (GME) and a handful of other company’s stocks with high short interests, dominated news headlines in January 2021 due to a resulting short squeeze and gamma squeeze. In the span of 15 days (January 12 – January 27, 2021) shares of GME were up almost 1,800% due to a rise in retail investors1, use of social media forums to discuss trading strategies2, a rise in options trading volume3, and a massive short interest of 138%4 of the float. 

What is a Short Squeeze?

First and foremost, a short squeeze could never happen without the ability to sell short shares of a company. To do this, an investor typically borrows shares of a company from a brokerage firm and immediately sells them in the market with the hope that the share price will decline and he or she can buy those shares back at a lower price and return them to the broker. (See Figure 1 for an illustration of short selling). 

short selling stock shares like Gamestop and GME

 (Image Source: https://www.thebalance.com/the-basics-of-shorting-stock-356327)

Short selling also comes with added risks including limitless losses5 and forced buy-ins6. Keep in mind that there are a fixed number of shares available to trade in the public market, and there are even a few shares available to trade if you take into account the shares purchased by investors holding long term. In the event a large number of short-sellers are forced to cover their short positions and there aren’t enough shares available, short-sellers must bid up the price to ensure the purchase of enough shares to cover his or her short position. To make matters worse, as the price goes up, more long investors purchase the stock in the hopes it keeps going up in price which removes more of the available shares the short sellers need to cover their position driving the price even higher. This sequence of events is known as a short squeeze. When a short squeeze is over the price of the underlying company’s stock typically falls quickly and sharply due to a lack of fundamentals justifying the massive price increase.

A gamma squeeze results from market makers hedging out the risk associated with selling options by buying the number of shares required under the options contract. This further reduces the number of available shares short sellers can buy when forced to cover during a short squeeze. As the price of the stock rises the more options are sold creating another feedback loop that adds to the increase in a stock’s price during a short squeeze.

How did the GME short squeeze begin?

In the case of GME, on January 11, 2021, GME announced that Ryan Cohen, co-founder of Chewy and former CEO, was joining its Board of Directors. This news caused an increase in the price of GME stock and forced many short sellers to frantically purchase shares to cover their short positions. The short interest reported at this time was roughly 138% of shares available for trading.7 Now you may be wondering how it is possible for short sellers to short over 100% of the available shares of GME? Well, it is possible for one share of GME to be sold short multiple times. For example, Investor A borrows 100 shares from Broker X and then sells the 100 shares to Investor B; Broker X then buys those shares from Investor B; then Investor A borrows those same 100 shares again from Broker X. This process can be repeated until over 100% of available shares are sold short. While the short sellers were trying to cover, many retail investors also joined in the buying of GME stock due to widespread efforts of individuals on social media platforms to encourage others to buy GME stock, as well as market makers that sold call options looking to hedge out risk. As the supply of GME stock available to purchase dried up, the price increased almost 1,800% in the 15 days to follow. However, the GME short squeeze would unravel in the days to follow due, in part, to flaws in the U.S. securities clearing and settlement process.

The GME Post Short Squeeze Drop

On January 28, 2021, problems began to arise after multiple brokerages either completely halted or placed trading restrictions on the buying of GME stock. Although the internet is filled with many conspiracy theories as to why some brokerages halted the buying of GME shares, the most likely reason was an increase in brokerage depositary requirements for the clearing and settlement of security transactions by trading houses due to increased risk from high volatility in GME stock. 

Typically, a brokerage submits its customers’ orders to a market maker that executes the orders. Once an order is executed, a clearing house performs the actual exchange of stock for cash. A transaction generally takes two days to settle because the clearinghouse needs time to locate the stock and cash to be transferred. However, brokerages generally allow investors to continue to make transactions, prior to settlement of a prior transaction, with unsettled funds. For this reason, clearinghouses require brokerages to make collateral deposits to cover the transaction during the two-day settlement period in the event one side of the transaction fails to deliver. Generally, clearinghouse deposit requirements are calculated by a formula. However, a clearing house can require additional deposit requirements to protect the business in times of high volatility or lack of liquidity. The amount of this additional deposit requirement can be subjective and not based on a formula.8 For example, on the morning of January 28, 2021, Robinhood received a request from the National Securities Clearing Corporation (NSCC) – a subsidiary of DTCC – at 3:00 AM for $3 billion in additional collateral due to what the NSCC perceived as risks from the volatility in certain stocks, including GME. By 5:30 AM the NSCC agreed to a reduced collateral requirement of $700 million. If Robinhood was unable to provide the additional collateral requirement, its trading privileges would have been halted for all securities. Thereafter, daily trading volume in GME dropped 37% from January 27, 2021, to January 28, 2021.9 The share price of GME fell from a high of $483 on 1/28 to $53.50 on 2/4.10

Takeaway

The GME short squeeze has shed light on some important issues going forward related to the use of social media platforms to promote a particular company’s stock, the ability of short sellers to short over 100% of a float and publish “short reports” on a particular company, broker dealers being undercapitalized in periods of high volatility, and the subjectivity of clearing house collateral requirements in times of high stress. Recently, the DTCC has proposed a one-day settlement for stock trades and Congress has held a hearing regarding these events.11 Only time will tell if and when these issues are addressed in order to avoid a similar situation from happening in the future.

 

Schultz Financial Group Inc. (SFG) is a wealth management firm located in Reno, NV. Our approach to wealth management is different from many other wealth managers, financial advisors, and financial planners. Our team of fee-only fiduciaries strives to help our clients build their wealth across four capitals: Financial Matters, Physical Well-being, Psychological Space, and Intellectual Engagement. We provide family office and wealth management services to clients located in Nevada, California, and other states. If you’d like more information, please check out our website or reach out to us via our contact page.

 

Footnotes:

1 https://www.cnbc.com/2021/01/22/trading-volume-is-up-so-far-from-2020s-breakneck-pace-as-retail-investors-get-even-more-active.html

2 https://www.jdsupra.com/legalnews/what-just-happened-the-gamestop-frenzy-2892854/

3 https://www.nytimes.com/2021/01/25/business/stocks-options-bubble.html

4 https://www.forbes.com/sites/petercohan/2021/01/15/with-138-short-interest-board-change-sends-gamestop-stock-soaring/?sh=1e4eb9366da8

5 The risk of loss is limitless because a stock’s price can, theoretically, keep going up.

6 A short seller can be forced to buy back a stock if there are no longer sufficient shares in the market to trade or his or her collateral drops below the required amount and he or she cannot cover.

7 https://www.cnbc.com/2021/01/22/gamestop-soars-nearly-70percent-trading-briefly-halted-amid-epic-short-squeeze.html

8 NSCC: Rules & Procedures, Rule 11, Section 6.

9 https://www.nasdaq.com/market-activity/stocks/gme/historical

10 https://www.nasdaq.com/market-activity/stocks/gme/historical

11 https://www.reuters.com/article/us-usa-markets-settlement/dtcc-proposes-one-day-settlement-for-stock-trades-idUSKBN2AO1YQ

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