Actions of GameStop (NYSE: GME) have seen an astronomical increase recently, with a short squeeze and gamma squeeze combined to force many purchases of their shares. Although those who bought in advance in anticipation of this result may be sitting well now, current investors should be careful. Grips like this rarely end well, and the same forces that caused your actions to fire can cause your actions to fall just as quickly, if not faster.
In fact, the worst mistake GameStop investors can make right now is to assume that the party will continue. Most likely it will not happen, and those who invest in believing this are the ones who will suffer the most when everything falls apart. have finally two huge risks faced by GameStop’s actions that could cause everything to fall apart. Failure to recognize them will cause problems for those holding the bag when the entire house of cards collapses.
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The options at the center of this gamma compression
The stock options themselves that helped boost the range tightening on the bullish path may end up fueling the collapse on the bearish path. Here’s why. On Friday, January 29, GameStop shares closed at $ 325 per share. According to data from Nasdaq.com, the following purchase options close to cash, but still within cash, appear to be open at the close of the market:
- 7,835 contracts at $ 320 per share.
- 855 contracts at $ 310 per share.
- 1,170 contracts at $ 300 per share.
When options expire in cash, brokers usually automatically exercise those options on behalf of their clients. And that is where the risk begins. Once exercised, each of these options contracts requires the holder to purchase 100 shares at the exercise price of the options. These three option contracts alone are forcing people to buy 986,000 GameStop shares this weekend, for a total investment of $ 312,325,000.
Image source: Getty Images
To get an idea of scale, a single $ 320 contract requires the investor to pay $ 32,000 to buy the shares at maturity. Sometime between the closing of the market on Friday, January 29 and the opening of the market on Monday, February 1, the affected GameStop options investors will wake up to find that they are now shareholders of GameStop. Not only are they shareholders now, but they also have tens of thousands or hundreds of thousands of dollars or more.
If these investors do not have the money or margin purchasing power to complete the purchase, their brokers will issue a margin call and forcibly close these positions by selling GameStop shares. Just as buying stocks and options forced short squeeze and gamma squeeze on the way up, the mandatory sale initiated by the broker resulting from margin calls could force the process to reverse.
When a broker forces a sale due to a margin call, that broker does not care about the price of the underlying asset. All that matters to the broker is to keep the account within the regulatory or contractual limits. This is a strong, structural mechanic why short gamma squeezes are so dangerous, double-edged swords that can revert as easily and quickly as they form.
Even if these newly formed GameStop investors are not forced out of their positions because of a margin call, many of them may decide to sell anyway. After all, it is one thing to bet a few hundred dollars on an option, but quite another to find yourself committed to tens of thousands of dollars (or more) in a very speculative stock position.
Beware of the cult of personality
In addition to the structural mechanics of short and gamma squeezes, GameStop investors face another risk, more directed at personality. At the center of the craze is a single Reddit poster (whose online username cannot be reprinted in a family publication), which regularly posted its stock investment progress.
The risk does not come so much from his posts, which largely consisted of just screenshots of the positions and values of your brokerage account, but rather the mass of those who followed you. The community’s comments in response to his posts are full of sayings like “if he still is, I’m still in” and all kinds of references to “attacking the man”. These are not said of rational investors and focused on valuation, but of people involved in an emotional movement or commitment to a person.
Emotional investment may work for a while, but it rarely ends well. First, those who continued to buy all the call options that caused the tightening of range may not have fully recognized the financial commitments they made when buying those options. Their fanatical commitment can quickly diminish, once they realize how deep their own pockets they have actually reached to participate in this movement.
Even if that doesn’t cause the stock to fall, at some point, the Reddit poster will decide it has gained enough wealth from that specific speculation and reduce or close its position. Its position – 50,000 shares and options to buy another 50,000 more – is just a small fraction of the daily stock volume and may not be enough to move the market on its own. When he sells, however, all investors like “if he’s still in, I’m still in” will likely rush to sell as well.
With the leader out and the mass of followers not far behind, what remains to hold the stock or keep those short lengths and range of quickly reversing? Worse still for those who are following, many of those who are holding it just because the original poster is still holding it will discover in the most difficult way how quickly the market can turn the other way. Paper profits can quickly turn into very real losses, especially when the drivers of the initial movement in one direction become the drivers of the movement in the opposite direction.
It is not a question of whether, but when
Short compressions and gamma eventually lose strength. Whether it’s because of the mechanics of expired options, the person in the eye of the storm deciding that he has made enough profit or for some other reason, GameStop’s momentum will also end.
Investors who are holding back because they think they will actually make money from the continuation of the trend run the risk of being the children of the poster of falling victim to the theory of the greatest fool. They risk losing everything they have invested – or even more, if there is a margin.
If you are an investor in GameStop shares or options, consider the real and incredible risks you are facing and plan and act accordingly. It is very likely that this party will not end well, and those who are more euphoric now may well end up suffering more when it ends.