Shares of GameStop (NYSE: GME) have risen astronomically lately as a short squeeze and a gamma squeeze have combined to buy many shares. While those who bought back early in anticipation of such an outcome may be sitting pretty at the moment, current investors should beware. Such squeezing rarely ends well, and the same forces that caused stocks to skyrocket can cause stocks to fall equally far, just as quickly, or even faster.
The biggest mistake GameStop investors can make right now is assuming the party is going on. It most likely won’t happen, and those who invest in the belief that it will are the ones lining up to get hurt the worst when everything collapses. There are at least two huge risks to GameStop’s stock that could cause the whole thing to fall down. Failure to recognize them will cause problems for those holding the bag when the whole house of cards collapses.
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The options in the middle of that gamma squeeze
The very stock options that contributed to the gamma squeeze on the way up could fuel the collapse on the way down. This is why. On Friday, January 29, GameStop stock closed at $ 325 per share. According to data from Nasdaq.com, the following expiring call options look near the cash, but still in-the-cash as if they were still open at the close of the market:
- 7,835 contracts for $ 320 per share.
- 855 contracts at $ 310 a share.
- 1,170 contracts for $ 300 a share.
When options expire in the money, brokers typically automatically exercise those options on behalf of their clients. And that’s where the risk begins. Once exercised, each of these option contracts requires the holder to purchase 100 shares at the exercise price of the options. Those three options contracts alone are forcing people to buy 986,000 shares of GameStop this weekend, for a total own investment of $ 312,325,000.
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For a sense of scale, a single $ 320 contract requires an investor to post $ 32,000 to buy the stock at maturity. Sometime between the market close on Friday, January 29 and the market opening on Monday, February 1, affected former GameStop option investors will wake up to discover that they are now GameStop shareholders. Not only are they shareholders now, but they are in the tens of thousands or hundreds of thousands of dollars or more.
If those investors don’t have the purchasing power of cash or margin to complete the purchase, their brokers will issue a margin call and forcibly close those positions by selling GameStop stock. Just as buying stocks and options forced the short-squeeze and gamma-squeeze on the way up, mandatory broker-initiated sales due to margin calls could force the process to reverse.
When a broker forces a sale due to a margin call, that broker doesn’t care what the price of the underlying asset is. All the broker cares about is getting the account within legal or contractual limits. This is a strong and structural mechanics of why short and gamma squeezes are such dangerous, double-edged swords that can flip over as easily and quickly as they form.
Even if these newly minted GameStop investors aren’t forced out of their positions due to a margin call, many of them can still decide to sell. After all, it’s one thing to bet a few hundred dollars on an option, but it’s quite another to find yourself betting for tens of thousands of dollars (or more) in a highly speculative stock position.
Beware of the personality cult
In addition to the structural mechanics of short and gamma squeezes, GameStop investors face another, more personality-driven risk. Central to the mania is a single Reddit poster (whose online username cannot be reprinted in a family-friendly publication), which has regularly posted its investment progress on the stock.
The risk does not come from there to be postings, which largely consist only of screenshots of the positions and value of his trading account, but rather the mass of those who followed him. The community’s response to his posts has been littered with statements such as “if he’s still here, I’m still here” and all kinds of references to “stick with the man.” Those are not the statements of rational, valuation-oriented investors, but rather people who are drawn into an emotional movement or commitment to a person.
Emotional investing may work for a while, but it rarely ends well. First, those who have been followed by all those call options that triggered the gamma squeeze may not have fully recognized the financial commitments they entered into by purchasing those options. Their fanatical dedication can quickly diminish once they realize how deeply they have invested in their own wallets to participate in this movement.
Even if that doesn’t cause the stock to fall, at some point the Reddit poster will decide that he has made enough wealth from that particular speculation and narrow or close his position. His position – 50,000 stocks and options to buy another 50,000 – is only a tiny fraction of the daily volume on the stock and may not be enough to move the market on its own. However, when he sells, all the “if he’s still there, I’m still sitting” investors are likely to rush to sell as well.
With the leader out and the multitude of followers not far behind, what’s left to keep the stock or those short and gamma squeezes of fast reversing? Worse for those who go along, many of those who only hold on because the original poster is still holding on will find out the hard way how quickly the market can go the other way. Paper gains can quickly turn into very real losses, especially when the drivers of the first movement in one direction become the driving forces behind the movement in the opposite direction.
The question is not whether, but when
Short squeezes and gamma squeezes eventually run out of steam. Whether it’s because of the mechanics of options expiring, the person at the eye of the storm deciding that he’s benefited enough, or some other reason, GameStop momentum will run out too.
Investors who hold on because they think they will make real money from the trend that continues, risk becoming the poster child of falling victim to the greater folly theory. They are at great risk of losing everything they’ve invested – or even more, if there is margin.
If you are an investor in GameStop stocks or options, consider the very real and incredible risks you face and plan and trade accordingly. It’s very likely that this party won’t end well, and those who are the most euphoric right now could hurt the worst when it ends.