- Steve Sosnick is the chief strategist at Interactive Brokers and chief negotiator for his Timber Hill business unit.
- Sosnick reviews the short squeeze and gamma squeeze that Reddit traders have implemented for GameStop.
- He also shared how the parabolic movements of these meme actions can permanently change markets.
- Visit the Business Insider home page for more stories.
The markets were dominated by the GameStop craze last week, and it was hard not to pay attention.
The traditional video game retailer that was about to die in the coronavirus-induced blockade increased by more than 1,300% last month.
GameStop’s stratospheric rise, driven mainly by Reddit’s WallStreetBets traders, brought down hedge funds like Melvin Capital and Citron Research. According to data provider Ortex, GameStop’s short-sellers lost about $ 19 billion in 2021.
And that is not all.
After Robinhood joined other major brokerage firms on Thursday to restrict GameStop trading, allegedly causing a 60% drop in shares before resuming its rise, the Securities and Exchange Commission said it was “closely monitoring and evaluating the extreme price volatility “so-called meme stocks. Congressional Democrats prepared to hold two hearings on Wall Street practices and online commerce.
So, how did it all happen? Although Reddit traders have often been described as unsophisticated and inexperienced young people dealing with stimulus checks from their parents’ basement, the strategy they employed – a short squeeze that eventually turned into a Gamma squeeze – is actually quite complicated .
To find out how these small retail investors outperformed hedge fund managers, Insider spoke with Steve Sosnick, chief strategist at Interactive Brokers and chief trader at Timber Hill, the company’s trading division.
A veteran trader with more than three decades of options and experience in stock trading, Sosnick recognizes a short squeeze and a gamma squeeze when he sees one.
What is a short grip?
To short sell a stock, investors need to borrow shares from their brokers. They will then sell the shares to others in the market with the expectation that the shares would fall.
When that happens, these investors will hope to buy the shares for less than what they paid to borrow them, in order to pocket the difference when they return them to the broker. This is a classic short selling strategy “sell high, buy low”.
The process may seem quite harmless, but the risk is that investors will have to repurchase these shares at some point, regardless of the price. Even if they choose not to buy these shares back immediately, they will have to deposit enough money into their accounts because the broker is lending the shares as collateral and they want collateral for the loan.
That’s why, as stocks continue to rise, brokers ask short sellers for more money.
Sosnick adds that another pitfall for the short seller is that if the stock lender sells, then the short seller will have to look for new shares to borrow. If the short seller is unable to find new shares to borrow, he will have to go out and buy those shares, whether he wants to or not.
“These two elements are what contributed to a tightening of the sale. Therefore, the stock either becomes too difficult or too expensive to borrow or starts to rise very quickly,” he said. “So short sellers are forced to cover their short sales. And if it happens fast enough, it creates a feedback loop and becomes a self-fulfilling prophecy.”
And that’s how the GameStop saga started.
Reddit traders took advantage of GameStop because it was one of the best-selling stocks on Wall Street. At a certain point, the share sold in the shares was 144% of the shares available for trading.
The huge short-term interest in GameStop meant that retail traders could collectively buy the shares, push the stock prices up and force GameStop short sellers to repurchase the shares to limit their losses.
This is exactly what happened, except that the losses were so huge that Citron Research, for example, had to cover most of its short positions on GameStop with a 100% loss.
What is gamma squeeze?
Short squeeze on GameStop turned into gamma squeeze when Reddit traders started using call options, a leveraged way to bet that stocks will rise.
To understand what gamma is, investors need to look at the delta, which measures how much you can expect from the option to move to a particular movement of the underlying stocks.
For each call option buyer, there is a call option seller or dealer who must protect his call option sale by buying the underlying shares; this is called a delta hedge.
If the delta remained unchanged for the life of an option, hedging would be a very simple activity. But the delta tends to change, and that’s where gamma comes in, which measures the rate of change of the delta over time.
As the value of the underlying shares increasingly approaches the exercise price of the call option, traders will have to buy more and more shares to hedge, further raising the share price. This is known as gamma squeeze, and this is what retailers have exploited to their advantage.
“Those who are sold on the call option are increasingly exposed to the stock movement because the options delta has changed and the stock price has risen,” said Sosnick.
“So anyone who short sells those calls, who needs to be covered, is in the situation of now having to buy more shares. Taken to the extreme, this becomes a kind of feedback similar to short squeeze.”
Two potential changes for the market
Short sales have been around since investors are short. Even gamma squeezes have been used by retail traders to increase stocks before. But the GameStop craze can have long-term implications for markets.
“If a strategy works, people tend to keep using it until it stops working,” said Sosnick. “This one has worked spectacularly well, so in the short term, the markets adjust.”
He thinks there will be two main adjustments. One is that investors will be more reluctant to short sell and short sellers will be more reluctant to take extreme positions.
That prediction came true when Citron Research’s Andrew Left announced on Friday that he would stop publishing short-selling surveys after 20 years. Instead, it will turn to long-term “multi-bagger opportunities” for individual investors.
The second consequence is that investors are likely to see call option prices systematically higher than their stock counterparts.
Sosnick explains that while there was a natural demand for sale protection and a natural offer of call option launchers above the market, there is now a radical change in the amount of demand for out-of-money calls, given the retail fervor to buy such call options.
“What is the logical thing that the market should do in this situation? Increase the price systematically,” he said. “There is always a price at which someone is willing to sell, but if the supply-demand equation has changed, people will systematically demand more money to sell the options.”