Using GameStop To Uncover Biases

2021 sure picked up from where 2020 left off. As if things couldn’t get any crazier than a global pandemic, a group of retail investors seemingly organized an epic short squeeze in GameStop Corp’s stock (GME) so violent that it bankrupted a $12.5 billion hedge fund. To be sure, a lot has been said on the topic. I certainly learned a lot about the technical aspects of what transpired. However, I learned a lot about myself too. The GME event triggered some strong emotional reactions. These helped surface some deep-seated biases which was an opportunity to analyze them and improve my thinking process.

Markets have a way of expressing the culture’s dominant philosophies. After all, they’re just collections of human behaviors. Today, postmodernism and nihilism are commonplace. The recent episode with GME illustrated just this. Specifically, a nihilistic narrative took root early in the absence of facts. It was a telling sign of the times.

GameStonk

GME is, by far, this young year’s biggest investment market story. GME is a video game retailer. Faced with many fundamental challenges, its stock was heavily shorted and declining since late 2013. However, something incredible happened. GME’s stock price rocketed up from $17—where it began the year—to nearly $350 in a matter of weeks; hardly normal behavior! However, this dramatic move did not result from some surprise strategic shift. Rather, the exploitation of a volatile stock market structure uncovered by some savvy retail investors (allegedly) on the Reddit social media platform, r/wallstreetbets (WSB), was to blame.

On the surface GME is a modern-day tale of David versus Goliath. It’s a story of the underdog, individual retail investors, taking down a mighty, short-selling hedge fund. The WSB crowd played David; Melvin Capital Management LP (Melvin Capital) was Goliath.

The Suits!

The WSB plan was simple: buy large quantities of GME stock and call options. The heavy short interest meant that as GME’s stock price rose the short sellers would be forced to cover their trades and compound the upwards pressure. Buying call options supercharged the effect (by creating a gamma squeeze). It was a tried and true strategy. (I explained this more in a recent interview found here.)

The maneuver worked like a charm. Within a couple of weeks GME’s stock price exploded upwards: to $50, $100, $200, $300, and flirted with $350! The shorts looked trapped. As the share price climbed so too did their loss. Soon, Goliath was mortally wounded. Two prominent hedge funds, Point72 and Citadel, stepped in to rescue Melvin Capital from insolvency.