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Some Implications of the GameStop Short Squeeze

Yves here. Reader vlade has graciously provided an assessment of what the much-discussed pitched battle between WSB longs (and likely hedge fund investors) and hedge fund who’d shorted GameStop and other past their prime companies like Bed Bath and Beyond. The stereotyping of the short sellers versus the longs has obscured critical issues about the mechanics of the trades and the likelihood that effective regulatory responses are likely to be few unless the SEC decided to make small fry market manipulators a priority the way it does now for insider traders (although vlade believes they could go underground were that to happen). Vlade doesn’t consider a transactions tax, which would throw sand in trading, no doubt because it’s not being discussed as a potential remedy.1

By vlade, Naked Capitalism’s longest-tenured commentor

January 2021 will go into the history. No, I’m not talking about US president and the Capitol riot.

I’m talking about the financial markets. The news of the skyrocketing small stock, and retail “investors” fighting against big evil Hedge Funds is everywhere. It made even on first pages of MSM, which in the current situation is quite an achievement.

Yves wrote about some of the misconceptions that were rife in the story. I want to write about some of the possible implications of the story for the future.

I will start with somewhat a technical one – if you want to skip it, please do, but I’ll try to make it layman-understandable.

The attack was on the “evil shorters”, with the implication that the retail investors wanted to trigger a short-squeeze.

As short sale is selling borrowed shares instead of buying, the shorter loses money when the price goes up. The short seller eventually has to close out his position by purchasing shares, which he hope to do at a lower price. If the price goes up, short sellers may reduce their position, depending on their risk, pain and margin appetite. To do so, they buy the stock. Buying of the stock in sufficient quantities can drive the stock up again, and when the price of the stock moves to the level where most of the shorters start buying, it can trigger a feedback cycle. The shorters buy to “cover”, and the more they buy, the higher is the price, so the more they buy. A short-squeeze is born.

A short-squeeze usually creates significant losses for the shorts. Short-losses are theoretically unlimited, and if the squeeze is fast enough, it can easily bankrupt the short.

But there is another way a short may take a short position – buy a put option. A put option is the right but not the obligation to sell a share at a predetermined price up until the option expiration date. Since a put is not a commitment to do so, the maximum downside is the outright cost of the option.

You can think “why would anyone _not_ do it?” Well, a lot of reasons:

– Options cost money, which is a realized cost immediately. Of course, borrowing a stock costs money too, so it may be a question of what the short considers cheaper
– The options are time-limited. When an option expires, the shorter needs to roll the position, adding to the cost.
– The options may be illiquid, adding both to the price and risk of rolling the position
– When the stock finally gets on an irrecoverable downward trajectory, it may become pretty much impossible to buy an option, which if it happens around the time you need to roll your options may mean significant part of the profit is lost

That said, the real question is – do the costs above outweigh the risk of unlimited losses?

After this January, a lot ot shorters may decide that the risks outweight the possible gains, and move towards using option more.

That has implications for short-squeezes. First, if all physical short positions were replaced by puts, the open short position would be smaller to start with1, possibly much smaller. Second, option sellers (brokers or option desks) have much tighter risk limits than an investor, and will reduce their risks – close their positions – much more aggressively.

These two are opposite forces. We have a smaller position, but one that would be closed faster. I believe it should make short-squeeze less likely (because of the smaller position to close), but if there is one, it will run much faster – both in the terms of liquidating the short positions, as well as how long it will run.

Using options also creates positive feedback due to hedging. In fact, the retail investors were buying calls exactly for this reason – to create positive feedback loop and send the price up even faster. The same, but opposite is true of puts, where strong downward moves can create more of selling via the hedging feedback.

Option hedging theory has a key assumption, that the hedging doesn’t move the market. We saw that’s untrue, and while some simplifying assumptions are useful, this one seems to be really dangerous. It’ll be interesting to seek whether any models that try to incorporate it make it into the mainstream, as dealing with positive feedbacks can easily end up in singularities. Which could translate into the new model saying “don’t sell options”. But even if it did, I’d not be surprised if the wish of making money selling options overrules the model2).

That brings me to the second implication. The models. Option pricing models operate in a “risk neutral” world. Amongst other things, it means that the models don’t care what the price actually means, if anything. It’s random (in a certain way), but otherwise there’s no difference to the model whether the price is created by a bunch of monkeys drawing numbers from a hat in a bunker, or has some fundamental grounding in the real world.

That is not necessarily how many economic theories see the price – they often assume that it has a linkage to the real world. Expecially the free market theories, as if the market price does not have a grounding in the real world, what does it say about their core justification for market activity, that it promotes “efficient distribution of resources”?

But the reality is, the price of an asset is a social construct. Its relation with the real world is only, let me repeat that, ONLY, via the society that sets the price. What I mean is that there is no physical, hard, restriction on the price, only the societal agreement.

You can say “What about bankruptcy, that puts the stock to zero?” No, it doesn’t (have to). We can see it best with the crypto, which is fundamentaly nothing but a few bits and an algorithm. Crypto has no “fundamental value”. Any value it has, is because some people agree (and/or believe) it has value. If people say that X has value, and sufficiently large part of the society accepts it, then X has value for any value of X (pun intended). The price follows the same, except more so.

As I wrote, unfortunately a lot of economic models assume that the price reflects the “real” value. The theories may acknowledge that the price is set by the society, but still have as a key assumption that it is, in some way, bound to reality. That the (majority of) pepole setting the price are rational in the specific way of binding it to the reality, that they acknowledge some fundamental (shared) value.

But, as we’ve seen recently, people may not only act irrationally, without any pretence of grounding the value in reality (hello Uber!), but they may on purpose manipulate the price so that it does not reflect the reality, intentionally breaking any link to the shared value.

To be honest, I know that some of the above is actually actively discussed and considered – but still too often pushed aside as “these are exceptions, we have studies that show the rationality wins” by the mainstream.

Even if it was true (which I have doubts about if we add “in any reasonable timeframe” condition), I do not believe it’s costless to the society.

The third implication actually follows from the second one again. Which is the question “If we have markets that not only can, but on purpose will, behave irrationally, what can we do?”

The GME started as a value play, but morphed into an open effort to hurt or destroy other market players. That very well matches the SEC definition of market manipulation. From the SEC website: “Market manipulation is when someone artificially affects the supply or demand for a security (for example, causing stock prices to rise or to fall dramatically).”

This was, in my opinion, an open stock manipulation, even anounced one. It was “We will destroy the shorters”, which has nothing to do with the fundamental value – and the only way to achieve it is to push the stock price (regardless of fundamentals) to the point of a triggering massive short-squeeze. This is not a conjecture – it’s what number of people on the various forums stated explicitly.

If a single investor engaged in this conduct, touting the price ramp up to “hurt “, the regulator would, at the very least, call them. More likely, the investor would be fined, especially if their stated goal was to hurt the short sellers.

Now, we have a group of investors doing the same. Should it be any different because they are retail?

I doubt that many of the people on the net took much care in what they wrote. The question is whether their comments can be tied to trading the stock at the same time. For example, people touting their real gains can be very likely traced almost trivially, since the regulator has access to all the info – all it takes is time.

Similar to the Capitol “visitors”, who are now finding that they may end up in a court for what they considered “a bit of fun”, many of the people who joined the GME (and similar) action may find themselves being investigated by SEC. Or may not. The SEC does as SEC will. C.f. SEC’s non-action on Musk.

If they do, then similar to the Capitol mob learning to be more careful, we can expect the stock gamers to learn quickly. Adverse selection works wonders in situations like these. People do learn.

The only way how the regulators could go after anyone right now is by connecting their trades to their comments. When people take care and take the communication underground, it would become harder, if not impossible for the regultor to respond.

In effect, the situation would be similar to a distribution denial of service (DDoS) internet attack – many small requests that overwhelm the system.

Of course, unlike DDoS, the market trades are traceable, but if you do it from hundreds of thousands of valid accounts, how can you prove that all (or even a majority) of them were conspiring to move the price? As opposed to just “ride” on it, in the same way as if they rode on a public annoucement of say a major deal?

I do not believe that the regulators currently have any reasonable tools to deal with this, and I also do not believe that the regulators can get any such tools without significant changes in the market structure. Yves has a post on Warren’s letter to the SEC, which deals with some of these issues.

Some people say “who cares, it’s going to hurt just the hedge funds, and they deserve it”, the answer is “No, it won’t”.

It’s not just stocks that are suspectible to this “denial of price discovery”, but anything tradeable. The latest was silver, but it can be any commodity.4)

The stock market might not have direct immediate impact on the economy, but commodity prices do. If oil or copper shoots up, it will affect everyone, not just the speculators.

Is it a price worth hurting a short? It’s been explained again and again that hurting specific hedge funds will hurt only a very small part of the financial markets, and by far<strong> not the most important. At the same time, it will make money for the rest of the financial markets, likely dwarfing any gains the small accounts can make – and if it’s a commodity under attack, it could hurt all of us.

I believe that these DoPDs are with us to stay. Once this particular cat is out of the bag, there’s no way to put it back – short of major changes to how the markets operate.

In the most likely scenario, these random market events start showing up now and then. As I wrote, that’s not necessarily seen as a bad thing by the Wall Street, but will cause random harm to real investors, like pension funds and suchlike, who as a result may move more assets to private equity. The market will be seen as even more of a casino by everyone. If commodities are attacked, we’ll all suffer5).

In the most extreme scenario, the WSB will turn to Joker – “Some men just want to watch the world burn” – as an inspiration, and these drive-by shootings will be daily occurrences. That would destroy the market, because it would become untenable to pretend that it would be anything but casino, moreover a casino where even the house has no idea of what the game is. But what would that achieve?

Again, at the extreme, with regulators giving up, it would in effect close the public markets, or perhaps more accurately, make it too obvious that only sharks hang out there. But the equity markets are but a fraction of the total financial markets. The banks make much, much more money in credit and interest rates markets, which are not open to the WBS and their likes 5).

At the same time, the pension funds – not just the defined contributions, but also the defined benefits – would suffer, and with it the pensions. They’ve become to depend on the higher returns that stocks have delivered for decades. They cannot live in a pure-white noise markets.

Most likely, they would take quick action to, for example, force their large holdings to go private, and give the management of the investment to some friendly-seeming private equity shop like Apollo. In effect, they would take the public markets private. And if you think inequality is bad now, just imagine what would happen if even more money were flowing into the coffers of firms that extract 7% a year in fees and costs, and take excessive risk with real world businesses because they do well even when they drive companies into the ditch, and along with them, jobs and communities?

____

1 Most option sellers will not run a naked option position. All major option sellers will delta-hedge their positions, meaning they buy/sell stock to limit their risk from the option. Put options need to sell the underlying stock, but because of their probabilistic nature, the required amout of stock to sell depends on the current stock price, option strike, and time to expiry. Simplified, the amout of stock needed to be sold increases as the option gets more into the money (that is, it would be profitable to exercise it). An at-the-money option, where the current price is the same as the strike, would have to sell a fraction of the share to hedge.

2 Which would be funny. Before the original Black-Scholes option model, which is widely used, the option market makers were running the pricing on various things. When BSM came, they started losing money to the BSM crowd for some time, because they wanted to keep making money the same way as before. Will a new model that will make money better come or not?

3 Commodity futures have been around for millennia, and are a useful economic tool. As long as you can limit speculation in them.

4 Inability to identify perpetrators has another impact – the ability to project anyone you wish as the perpetrator. I hear cries of “Russia Russia” or “China China” comming.

5 Some are, via futures. But futures are cash expensive, and any “distributed” attack would be over very *quickly as a central bank would step in and ruin them all (because they have deeper pockets than any investors). If lucky, the small guys would get a warning shot before the nukes were deployed. If not, there would be a lot of suicides.

____

1 Robert Reich mentioning a transactions tax on Twitter is proof of his not being part of this debate. He’s come up with what Erin Brockvich would call wild assed estimates of what it would raise because he’s utterly missed the plot. A transactions tax is a Pigouvian tax. Even a modest transactions tax would end HFT and would dent derivatives trading, since traders need to adjust their hedges frequently. It’s not hard to imagine that a financial transactions tax would cut trading by 50%, although many big financial players would find a way to book trades outside the US to avoid the charges unless it was designed to be comprehensive and capture all dollar-based transactions (which could be done since all dollar activity ultimately clears though banks that have US banking licenses and use Fedwire. But it would take awfully careful design and drafting).

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89 comments

      1. Dr Sloper Waz Robbed

        Thanks to all soapbox providers and users mentioned.

        Only note of divergence I can think of is that I have noticed that many of these GME, AMC and so on rabble-rousers are making the holding of the stock the main thing. And they are buying things they believe in/want to believe in again (I guess hanging out in the mall and playing video games and watching movies, eg). They’re voting with their money-feet, they’re (saying)they’re gonna buy and hold.

        Naive? Doomed to fail? Maybe even worse? Who knows. But what if all that becomes a thing for the millennials etc, buying and holding what is believed in and so on.

  1. Sean

    Chamath Palihañitaya might be the easiest target with his tweets which include
    1. Recognize that the hive mind of the group was effectively acting as one
    2. Recognized mechanics of short squeeze
    3. Trades the stock

    Billionaire so deep pockets to sue.
    https://mobile.twitter.com/chamath/status/1355580731980869637

    Cuban gets a little close with advocating for withholding borrowing and having his son trade gme but I don’t think crosses the line.

    1. Yves Smith Post author

      I wouldn’t be at all sure about the son trading being seen as a credible independent party. I know a former McKinsey partner, Purnendu Chatterjee, who later became a VC. His brother in law was caught out insider trading with information coming from Chatterjee. Chatterjee paid $3 million in the settlement, where he pleaded nolo contendere. However, that was back in the days when the SEC had some spine.

      1. Sean

        It’s like a 12 year old son who he said had bought 2 shares. In my opinion that won’t count as participating.

        Chamath i think is in a tougher position.

      2. Sean

        Also if they were going to enforce anything the oil expiration when it went to -60 would be the play. Those contracts were cash settled elsewhere with Chinese banks. There was definitely banging of the close to manipulate settlement.

        Of course during covid there not going to enforce regulations where the primary counterparts was Chinese banks.

        1. vlade

          For exchange traded contracts, the cpty is always the exchange. Which has a margin position with the other parties. If the chinese banks were not posting the margin, they would have been out on their ear very quickly.

          1. Sean

            I would have to review it but I believe the Chinese were in a cash settled contract that based its value on the closing price of the future. So getting the future to officially close at -60 made those contracts cash settled price -60 despite the fact the futures contract was positive a few hours later

  2. Diego M

    There is nothing ‘artificial’ nor ‘natural’ in a stock price.

    It is not artificial to buy a stock whose price you think will be higher in the future due to the actions taken by *other market participants* (e.g. putting themselves in an extremely fragile position).

    There seems to have been coordination in manipulating GME’s stock price recently (as in lowering the price *exclusively* due to their own actions) on the part of the short-sellers:

    https://www.reddit.com/r/wallstreetbets/comments/lalucf/i_suspect_the_hedgies_are_illegally_covering/

    I can imagine the SEC going against DFV and others and not attempting anything against hedge funds’ daily, huge frauds. However, I won’t back it.

    1. Yves Smith Post author

      Sorry, I vehemently disagree. Momentum trading is speculation and prices determined by speculators are divorced from fundamentals. And there are models for valuing stocks (go read Ben Graham or textbooks on securities valuation) even if the people preparing the models can have considerable differences of opinion as to what the inputs to the model (the assumptions about the company’s future performance and the appropriate discount rate might be). That is not at all the same as speculative trading. As Keynes said:

      Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done… The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.

      Please identify the hedge funds’ “huge frauds”. You are coming close to “extraordinary claims require extraordinary evidence”. The SEC did go after SAC and separately managed to convict a former McKinsey managing director, as in head of the firm, on insider trading with a hedgie (who also got nailed). But the SEC has also been all about insider trading for years.

      Having said that, it also got under Dodd Frank regulatory authority over both hedge and PE funds and started doing on-site exams. It found widespread abuses among the far more politically powerful PE funds. It did fine pretty much every top firm, even though the fines were on the order of doing business level and the SEC took the naive or lazy posture that these were just mistakes by otherwise upstanding players and that the investors, now having been wised up to the abuses, would ride herd on the funds.

      By contrast, the SEC would have a way way way better understanding from the get-go of hedge fund operations, yet their initial round of exams didn’t turn up any large scale abuses.

      Note that hedgies, because customers require monthly independent valuations, plus the ability of customers to vote with their feet via redemptions (usually 3 month to one year notice) have vastly less latitude to play games with customers than PE does.

      The widespread assertion that Citadel was front-running Robinhood order flow is very likely to be urban legend. Readers who know Citadel and have no reason to lie for them say they run a legally very tight shop. The loan to Melvin was probably due to having a prime brokerage or counterparty exposure, and lending being a less costly way to deal with the problem than let them go into a spiral. Plus there are enough allegations about Citadel that the SEC will probably have to have a look anyhow.

      The problem is that a lot of activity that is not at all healthy, like HFT and IMHO selling order flow, are perfectly kosher.

    2. vlade

      So, when WBS crowd run up the price (due to their own actions), they are the good guys, but when short sellers lower the price (due to their own actions), they are the bad guys? Right.

      Your link is a proof that those guys are clueless, QAnon for stock traders.

      Shorts cannot “illegaly cover”. The only way to cover is to buy a share back, and then return the stock to the lender.

      I.e. HF buys a share from S, and delivers it to L. The deliveries are either by S to HF (who sold the share to cover), or by HF to L.

      If S fails to deliver, how’s that HF acting illegaly? Sure, they have a problem – because they were counting on the delivery to cover, but if anything, it was them who was s-wed.

      If HF fails to deliver to L, then HF’s position is still the same, they didn’t cover the short. If you haven’t covered the short, they could not have illegaly covered the short.

      IF shorts were doing anything with fail-to-deliver, it would be _more_ of shorting, and it would be illegal, as naked shorts are. It would be extremely easy to show.

      I wish those people actually used the brains.

  3. Chas

    Vlade has missed one important point in the discussion, namely leverage, although this helps his argument in some places and hurts it in others. Call it market manipulation or whatever you want, but the actual root cause of what happened over this past week is excessive leverage, regardless of whatever proximate activity actually triggered the squeeze.

    When you engage in short selling, you are taking on leverage (this is obvious since you begin the trade by *borrowing* shares of stock you must eventually repay). Using leverage makes you vulnerable to squeezes (typically margin calls), and the HFs involved on the short side of this trade not only used the leverage inherent in shorting, but also further levered their investment strategies in many cases 3x, 4x or more. If regulators wanted to prevent this kind of situation from occurring again, the question is not how to prevent “market manipulation,” but how to restrain leverage, particularly when concentrated in one name.

    Vlade is correct to point out that commodities markets are even more vulnerable to this type of damage, but not only for the reasons he cites. An important one is the fact that derivatives allow market participants to take on *even more* leverage than the stock market. Thus the potential for even more dramatic squeezes exists.

    All levered strategies will eventually be squeezed given enough time, whether by “market manipulation,” news flow, or simply changes in credit conditions. Preventing damage is a question of limiting the use of leverage itself, not trying to douse every match or spark that could start a forest fire.

    1. vlade

      Leverage is a somewhat different problem, and it’s not a new problem – as Yves keeps writing, the GFC wasn’t a credit crisis, or a mortgage crisis, it was a leverage crisis, and I’d argue that any systemic financial crisis will be a leverage crisis.

      But they key part is, it’s not new, it’s already there, and even as a key part of system crisis, it’s still survived.

      The points I am making were actually ordered in terms of the implication severity, although I didn’t make it explicit. The first point is IMO the least important. It’s possibly still important, as a substantial increase in put options would change the market structure. But substantially, it would be the same market.

      The second point is more important – the disconnect of the price form reality, but again, we already had that, it’s just “more so” (if I really wanted to pick on that as the main theme, I’d use crypto).

      But the cheapness of a “denial of price discovery” is something new. The ability to turn the market into a white noise quickly and cheaply, and with the regulators unable to do much except to shut it down, that’s new.

      1. Ignacio

        Your description of how arbitrary are, or can be, asset prices is very good. How some or many markets including stocks can be seen as nothing but mere casinos has been my view that I share and agree with some people involved in the world (game?) of mutual fund management.

        I was wondering if the GameStop event is something that has been indirectly triggered by the Covid pandemic, out of boredom and lack of opportunities by traders. In such case, shouldn’t we expect and fear, very much like you made us note, that this could become daily news in stocks and later expand to other stuff… err.. assets?. I always believed that in the particular case of commodities, the derivatives markets might never turn as arbitrary as in stocks but indeed it is conceivable that someone or some many, for fun or for harm, could basically do the same.

        Would you, in that case, expect any type of official response, possibly beyond the scope and competencies of the existing regulatory institutions, to reduce the damage or to divorce the casinos from the real selling price of commodities?

        Thanks a lot for your contribution! Excellent even if I had trouble understanding the details of short selling (I confess to be, may be willingly, unable to catch it in its entirety)

  4. Kasia

    I’m confused. I’m just a normie; this is obviously not my specialty. You first state that stock prices are “socially constructed” and have no relationship to “reality” and are not “rationally” set. This, my normie mind can totally grasp and I am ready to believe it. But then you quite quickly segue into “manipulation”. Stock prices are manipulated to have no relationship to “reality”. In other words social forces are constructing these stock values. No? Is there a distinction within the realm of social construction? Are some social constructs good while others bad. Are social constructs that stay close to “reality” good while social constructs that stray far from “reality” bad. Who is the decider of this “reality”? Or must we judge the intentions of the social constructer of stock value? I could go one step further and hypothesize that all human knowledge is socially constructed. The question then being, is there an example of non-socially constructed human knowledge?

    1. vlade

      Ok, I’ll try to explain.

      The issue here is twofold. First, stock prices are notoriously hard to relate to reality, and must be, because even under an entirely rational market theory, their value depends on future – and there’s an infinite number of futures one can imagine. That’s what people mean when they talk about “price discovery”, that all the information that’s somehow available gets averaged out into some future. And this future is clearly a social construct – processing the available information by a society.

      Now manipulation is moving the price _disregarding any of that_. It’s moving the price purely to move the price, in an expectation of a reaction when price reaches some level(s). The only input into the price is the wish of the manipulator.

      I believe most of the people would agree that some social constructs are good, while some are bad. Of course, they will often disagree which are which.

      Re your last point. Laws of physics, which are a human knowledge, are not socially constructed – they are hard, reality limits. No matter what we humans do, we can’t make an apple to revert back to a flower it came from.

      1. josh

        “Now manipulation is moving the price _disregarding any of that_. It’s moving the price purely to move the price, in an expectation of a reaction when price reaches some level(s). The only input into the price is the wish of the manipulator.”

        Sir, this is a casino. The game is poker, not blackjack. Trying to tease out some difference between manipulation and honest valuation in a market that puts TSLA at $800 billion is a fools errand.

        The problem for the SEC isn’t the price manipulation. The problem is that retail figured out the game.

        1. vlade

          Indeed, and that is _precisely_ my post’s point. Because when only big boys had capacity to do it, SEC could have at least pretend that the market was “allocating resources”.

          When the price manipulation can be had so easily and anonymously, the public markets could be done for.

          But to continue your similar further, even if you close the poker table in the casino, the casino stays. Even if public markets would go poof, the financial casino could turn into something _worse_ and less visible. It has plenty of skill in doing that.

      2. Kasia

        Thank you! I can see the distinction is between passively anticipating a future or actively willing it. You can see there is an asymmetry of power here. Powerful players can actively will the future on CNBC with near impunity while hiding behind a “moral” shield that disallows this same activity to the herd. In any case the herd on Reddit were very clever in confusing their intentions in their comments. The four main tropes were, “I like this stock” which is mocking CNBC. They called themselves either “retarded” or “apes” and in the end they blame everything on their “wife’s boyfriend”! Regime elements in the SEC will struggle to understand all this inside chatter.

        The concept of “laws” of physics is a metaphor taken directly from the Abrahamic religions which projects an all powerful deity as the lawgiver, and thus is a total social construct. An apple most certainly can turn back into a flower if its seeds are planted and nourished.

      3. freedomny

        I honestly don’t get this. A stocks value (as an asset) depends on the future..? Maybe this is why the stock market is so messed up and operates like a casino. Really trying hard to think of another asset that is dependent on the future. Real estate isn’t, it’s value is based on the current comparable market if you are using a loan to purchase the property. If a real estate agent has an open house and sells the property to an all cash buyer for ten times the current comparable value and then sells another neighborhood property for the same price but with a bank loan….is that considered speculation or market-momentum manipulation? Because there is a very good chance that second buyer will get a loan from the bank.

        The problem with the stock market and Wall Street in general is that common sense does not prevail. Wall Street loves to make it sound like it’s all very complicated and esoteric. Because in many ways they have deliberately made it overly complicated in order to cloak their corruption. You can practically hear the absolute disdain from CNBC wealthy commentators and academic types explaining how only those in the know could possibly invest successfully or understand the elaborate intellectual labyrinth that is Wall Street To many, including myself, it all sounds like a bunch of meritocracy bs.

        I’ve been waiting for anyone from anywhere to successfully explain to me – an absolute moron, dumb as a doorknob person – why a bunch of disillusioned people on a public forum trying to use their OWN money to fight back against a Wall Street (and try to make some money) that has crippled them/their families or disgusted them is somehow wrong or corrupt. I’ve heard nada.

        And if it is too hard for the average person to understand…..wake up and realize that is probably the problem.

        1. Yves Smith Post author

          Yes, please go read up on any valuation model. The value of a stock is the forecasted after tax free cash flow., as in expected in the future. That’s what is left to stockholders after all obligations are paid: employees, debt, litigation, taxes, etc. That is discounted back to the present by a discount rate that reflects the riskiness of the future cash flows.

          Yes, as you can see, many assumptions! Differences in those assumptions can easily lead to a difference in value, on an entirely rational basis, of x to 5x. Much much more with an early stage tech co.

        2. ChrisPacific

          Really trying hard to think of another asset that is dependent on the future.

          Try mortgages, or insurance policies. Both are about accurately pricing future risk. The insurance industry has a whole discipline (actuarial science) devoted to it. If you sell insurance, the policy becomes an asset on your books, and needs to be priced, even though you don’t yet know whether the insured party will ever claim.

  5. john

    A number of years ago, I met an oil trader who spoke at a CFA society event about his profession. He described the prevailing trading strategy as “identifying the weak hand in the market, then crushing it.” Find the trader who has overextended themselves on leverage and is unable to take physical delivery at expiration and force them to close out positions at unfavorable prices. This sounds more like a poker game than fundamental valuation. If you’re sitting at a poker table for 15 minutes and can’t identify the sucker, then you’re the sucker. The Fed killed fundamental analysis by inflating asset prices for 10+ years.

    Everyone long GME knows the stock is fundamentally overvalued. Vastly overvalued. However, there are very valid technical factors related to the supply and demand of the stock to justify its price increase. I take issue with vlade’s citation of the market manipulation definition. Supply and demand have been affected (artificially or otherwise) first by the short sales. The retail traders are simply expressing a view on demand for GME shares. Regulations between these two markets aside, why is this behavior ok for professional commodity traders and not retail?

    1. Yves Smith Post author

      There is a big difference between the commodities markers and stock: there’s no insider trading under the law. It’s assumed that no one player can possibly have enough information to have reliable advanced intel.

      And you need to bone up on what market manipulation and collusion amount to. One trader taking a position based on the notion that there’s a whale in trouble is not market manipulation or collusion. A bunch of traders in parallel coming to the same view, noticing trading action that strongly suggests other traders are acting to squeeze the whale and deciding to increase the pressure based on their reading of trading is not collusion or manipulation.

      Traders communicating about their intent to crush the whale in the hope of getting others to join, PARTICULARLY for traders too small to move the market individually, sure as hell looks like collusion. The SEC would just need to do the work to firm up its case.

      1. KiWeTO

        There is a fine line between pointing out something is overvalued or undervalued, and actively encouraging (inciting?) market participants who are independent decision makers to buy or sell or hold.

        What is the difference between the hordes of youtube market commentators telling(advising?) their audiences to buy/sell vs a professional stockbroker? (Besides licenses and much better regulation of excesses.) Should the SEC also look to regulate every youtuber who comments on the markets to prevent future “collusion”?

        At one level, this was demagoguery inciting a pile on. At another level, it was independent decision makers choosing to chase the money from a temporary unicorn. It is both and neither at the same time.
        Let’s also not forget the investor choosing to defend their childhood memories while seeking to make a buck. How different is that belief vs an environmentally green investor in another stock? They are all right and not right at the same time?

        Collusion is usually between market players with some ability to move the price. This was demagoguery at its finest getting volumes of retail players to choose the same way, and probably not quite covered under existing regulations?

        This genie is out of the bottle… and the markets will probably be worse off for it.

      2. john

        I have boned up on the definitions and I’m just not seeing anything blatantly illegal. First off, nobody traded GME on inside information. Retail coordination aside, Ichan crushed Ackman on his Herbalife short in a similar manner and was celebrated in the financial press. They called it activist investing. Other institutional investors piled on to ride Ichan’s coattails and Ackman’s fund lost millions.

        Most dictionary definitions of collusion include the word “secret”. Typical collusion activities are agreeing to divide market territory, bid rigging, kickbacks and price fixing. One could make an argument that this constitutes price fixing, but again price fixing is done in secret. Not on open forums for the world to see.

        Most of the classic examples of market manipulation don’t apply. This wasn’t a pump & dump. There was no churning, fake price quotes, price ramping or false rumors. One could argue this was an attempt to corner the market on GME shares in a decentralized, distributed manner. It will be interesting to see what existing rules, laws and regulations have to say. I’m no securities lawyer but I imagine they are more geared towards small groups of wealthy individuals and institutions (like Form 13-F holdings disclosures) rather than a decentralized retail army. Speaking of 13-Fs, activist investors game the system by holding quantities of stock just under the filing requirements. They then seek out partner funds (in secret) to purchase shares and join their activist campaigns.

        Maybe the SEC can firm up its case. If they can’t, they’ll undoubtably request new laws and regulations to prevent this sort of thing from happening again. If they choose to go down that road, I’d also suggest a preemptive ban on pitchforks, torches, tar and feathers.

  6. Dave A.

    I am also a normie but I sense a bias in favor of elite speculation here, which surprises me. We have many recent and primary examples of market manipulation (RMBS, CDOs, etc) quite clearly designed to enrich a small club at the expense of supposed fundamentals, which to me is another word for honesty. In another example directly related to this piece, it is my understanding one of the aspects of the short of GME was that the position involved 140% of the outstanding shares, which is supposedly illegal as I understand it. In my opinion, if we are to even begin to restore a sense that honesty exists in the market, any regulatory action must begin, and perhaps end, with recognition that speculation has long been tilted to elites.

    1. vlade

      No, it’s not illegal. All the “one rule for small, another for large” cases on this are just plain ignorance and misunderstanding at best, misdirection at worst. Why is in different comments scattered around the post.

      Given how often it’s repeated here, when it was refuted again and again, I’m almost tempted to do a “GME Myths busted” template comment to attach as a comment 1 on any future discussions on GME and similar, so that people have no excuse.

      1. Dave A.

        Vlade, I think you and my former boss at the AGO would get along great. Heh. I don’t think there is serious disagreement that too big to fail or jail is the prevailing (lack of) enforcement premise. I also don’t think there is serious disagreement that big players have engaged in actionable deception that has gone unaddressed because of the TBTF infection. My guess is the very bigs are the reason why shorting 140% in this instance will be blessed or overlooked. Thanks for the reply soap box, NC. I hope I have not strayed from the comment policy. No misdirection intended.

  7. The Rev Kev

    You were saying that ‘The GME started as a value play, but morphed into an open effort to hurt or destroy other market players’ and I can agree with that assessment. Only thing is, from my own reading it seemed that those other market players were involved in a calculated effort to short Gamestop into bankruptcy eventually. And I would not be surprised if there was not a bit of collusion going on here between those players to do so. And I have even seen the term ‘naked shorting’ also used elsewhere to describe what those players were doing. Isn’t that supposed to have been made illegal after 2008?

    1. John Wright

      How does ” those other market players were involved in a calculated effort to short Gamestop into bankruptcy” actually get accomplished?

      In other words, if Gamestop stock dropped to zero as a result of short sellers, how would the business operations of Gamestop be harmed?

      A company’s outstanding stock is like a used car one sells to someone.

      If the market value of a seller’s former car drops, this has no effect on the original sellers’ net worth UNLESS the original seller has many more used cars to sell or has some sort of price protection requirement on the originally sold car.

      In other words, a falling stock price should have no effect on a company’s income statement UNLESS the company has some financial guaranty active, such as Gamestop selling put options on its own stock or Gamestop was planning to sell a lot of equity on an emergency basis and had to substitute interest paying debt instead..

      Was Gamestop obligated to support its own stock price by some legal requirement?

      If not, how can it be forced into bankruptcy by a lowered stock price?

      1. The Rev Kev

        Not a financial guy here obviously but what are the chances of a company like Gamestop getting needed financial loans when the ‘official’ market is saying that, via stocks, they rate them as a dud company. If you were a bank and saw their stock doing nothing but descending, would you loan them money?

        1. vlade

          Irrelevant. The bank would look at their cashflow and hard assets. Only if they were really distressed would they look at their ability to raise equity. As a matter of fact, an undervalued equity for a viable business would very likely attract significant interest.

          GME by all accounts was sitting on a pile of cash (about half a bil).

          1. Hugh Fowler

            GME by all accounts was sitting on a pile of cash (about half a bil).

            Which might be a reason for people to want to short the shares as the preparation for a hostile takeover. Crash the share price, buy a majority share holding at discount, take it private and asset strip.

            1. vlade

              Once you start buying, the price will start going up, and at very discounted price it may be not just you who notices it. Risky strategy

          2. Susan the other

            so question vlade: doesn’t this make the hedge funds’ ill-fated short of GME look more like piracy? Private equity style piracy? If GME had all that cash it was very attractive not as a failing business to be shorted but as a cash treasure chest – it would have been a no-brainer for the hedge funds to short it and buy it up at pennies on the dollar, literally. Obviously price discovery doesn’t really account for the actual value here because the business was failing – where there really was value, the cash, it was obscure to the world. Except for the parties fighting for it. There is a fine line between private equity and hedge funding in this instance, isn’t there?

            1. vlade

              Well, no. The short thesis was that even though GME has a lot of cash, it’s burning through a lot of cash (a year ago it had 1bln in cash), and it’s business model doesn’t work.

              Basically, they bet that GME is in the same boat as Blockbuster was a decade ago Blockbuster tended to generate tons of cash. Until internet and Netflix, when it went from hero to zero in space of a few years.

              The shorts saying that GME will end up the same when competing against digital distributors like Valve’s Steam, Epic, CDR’s GoG etc.

              In my opinion regardless of the last week, it’s still the most likely outcome for GME.

              The shorts will right and manage to lose tons of money at the same time.

            2. Yves Smith Post author

              Hedgies are not in the business of buying and operating companies. A successful short is clean and simple: it’s just buy low, sell high, but executed in the reverse order.

              It’s not unheard of for companies with weak prospects to still be cash-heavy. , Apple looked like a total goner in 1997 and had more than its share value in the value of its cash, yet everyone debated if it would make it. The reason it did was that Microsoft made a $150 million (IIRC) loan, which was a signal that Microsoft could not afford to let Apple go, they were afraid of the antitrust implication of being the only PC operating system. And then Apple bought NeXT to get the NeXT operating system (which did become the foundation of OSX 10) and Jobs turned Apple around.

    2. vlade

      “to short Gamestop into bankruptcy eventually”.

      That is impossible. You (and others) are confusing a cause and effect. I wrote it in another comment, but will repeat it.

      Yes, bankrutpcy means that the price of equity can be 0 (doesn’t have to be, depends on what’s left). But equity at zero doesn’t mean bankruptcy.

      Think about it. The bankruptcy is the inability to pay your liabilities. Book equity is the difference between your assets and liabilities. But the _public_ price of that equity does not magically increase liabilities, or reduce assets. If I’ve a company that has 1bln in the bank and no other assets or liabilities, it can have whatever share price it can have and it’ll still not be bankrupt.

      You cannot short a company to bankruptcy. In fact, given GME’s cash pile, the shorts would not, in any reasonable timeframe, get even close to anywhere to zero, because say when the share price of GME was 1/10th of its cash pile, someone could have just buy enough to get a controlling interest, install a new board, delist them, and pay himself out the cash.

  8. RGF

    RE: “Most option sellers will not run a naked option position. All major option sellers will delta-hedge their positions, meaning they buy/sell stock to limit their risk from the option. Put options need to sell the underlying stock, but because of their probabilistic nature, the required amout of stock to sell depends on the current stock price, option strike, and time to expiry. Simplified, the amout of stock needed to be sold increases as the option gets more into the money (that is, it would be profitable to exercise it). An at-the-money option, where the current price is the same as the strike, would have to sell a fraction of the share to hedge.”

    Two things here: Remember that a short put/long call of the same strike and same expiration is almost identical to owning the stock at the strike price. And that a short call/long put of the same strike and same expiration is almost identical to a sale of the underlying. Therefore, if you are “long” the underlying (be it a stock or a commodity) and buy a put and sell a call of the same strike and same expiration, you have totally eliminated the risk in owning the stock. The mirror image is that if you are short the underlying and buy a call/sell a put of same strike and expiration, you have totally eliminated the risk is being short the stock. So, in addition to using the stock as a way to stay “hedged”/price neutral, using other options performs the same function. The preceding examples are called “conversions” — converting an options position into an underlying (stock or commodity) position or vice-versa.

    Second, there are multiple strike prices of both puts and calls of the same expiration. The distance (price difference) between the strike prices varies, but $5.00 is a common one. So if you sell a call with a strike price of 50 and buy a call with a strike price of 55 of the same expiration, the maximum loss you will incur is $5.00 minus the difference in the cost of the two options. The mirror image is of course true, except that the maximum gain is limited to $5.00 plus the difference in the cost of the two options.

    The market maker’s objective is to use all three (underlying, puts, and calls) to extract a margin.

    In the old days, before electronic trading platforms were invented, the market makers were math majors from MIT (or high school grads who COULD have gone to MIT) who realized that standing around on the floor of an exchange mental math gymnastics for up to 6 hours a day was both fun and lucrative.

    Thanks to vlade for writing this. It brought back memories of the floor of the NY Cotton Exchange back in the 1980’s when I was more or less a regular down there.

    1. vlade

      If you do the synthetic long/short, the total delta in the market will be the same as if you shorted it outright, you just distributed the short positpons more.

      But if you buy a put, the total delta in the market will be less than 1, so a smaller position to close. And, as he stock goes up, it will be less and less and less, as it will be actively managed. A on a short outright postition, moving say from 50 to 52, the delta could happily be the same, as the shorts just eat the temporary pain. The option maker would rehedge, and the short delta position would decrease. There’s no way that an option desk would have a short delta hedge on with a stock @100 and the strike @50, their risk department would get the traders fired. Shorts, a differnet story.

  9. PlutoniumKun

    Thanks Vlade, a very clear explanation for someone like me who has never had any involvement with these markets.

    Michael Pettis in Beijing commented on this that it reminded him of almost weekly occurrences in the wild west that is the Chinese stock market. Wild fluctuations happen there all the time driven by waves of small investors, usually being manipulated either by big players, or smart small investors. The inevitable result of course is that big institutions stay clear of it, leaving it to manipulators and well resourced gamblers.

    I used to think that widespread stock market investing was a US thing, but recently I’ve been surprised – and horrified – at how many people around the world are doing it, many with very little clue of what they are getting into. It seems to me that the big danger of the stock market is not some sort of systemic crash, but of relatively small shocks plunging people who have little or no savings into debt – not just in the US/China or Europe, but i believe this type of betting has become extremely popular in many developing countries.

    1. vlade

      This is an interesting thing, one I didn’t think of. Of course, the Chinese market is comparatively small (about a fifth or less of the US one), and not nearly as critical to the world’s public equities markets, but it can give some sense of where the US can be heading..

  10. José de Freitas

    As usual, not only is the original post excellent and chock full of information, but the comments add layers and layers of intelligent analysis and discussion. Naked Capitalism rules.

    1. Evan

      Sorry, this is a random comment I used to ask a question about this line “[a] short sale is selling borrowed shares instead of buying”

      This triggers layman’s cognitive dissonance and I can barely make sense of anything that follows.

      The problem is the assumption that I would know that you can buy borrowed shares. I don’t, I’m just a layman.

      How do you buy borrowed shares?

      If you can, how do you liquidate them?

      And what is the term for buying borrowed shares?

  11. Andrew Watts

    One of the things people seem to be overlooking in the GameStop mania is the vast potential for securities fraud. On the WSB subreddit there are a few people who encouraged the buying of stock while they were actually selling their holdings. The willful misrepresentation of their actions seems like it might qualify as securities fraud. Multiple posters on WSB openly admitting to this makes the SEC’s job easy.

    I was expecting an outbreak of investment mania like the railways in the 1840s, or the dotcom bubble, but this seems much different. There were a lot of half-bright* individuals in their teens and twenties who traded during the dotcom bubble era. Afterward I watched them lose money getting squeezed by Wall Street. Especially on days when their options expired. But the more I think about the GameStop mania the more painful I think it will ultimately be beyond the money that will inevitably be lost,

    This looks like the last desperate attempt of my generation to live the American dream.

    *Not an insult. I was an idiot teenager who lost big during the baseball card collapse.

  12. ROC

    Fascinating! If this episode results in less short selling, wouldn’t that lead to less volatility caused by “jokerfied” Redditers? Their attacks seem to be directed at vulnerabilities in short seller positions. I’m wondering if there are similar vulnerabilities in “the system”, or if this is somehow unique. It just seemed like the perfect storm to me (If not already obvious, I am definitely a layman on this topic).

  13. voislav

    One thing that should be mentioned is that Gamestop was an unique situation, not an ordinary short play. Before the stock popped shorts held by institutional parties amounted to 140% of the total Gamestop stock (all shares in existence), meaning that there was substantial naked short-selling. This made hedge funds like Melvin extremely vulnerable to a short squeeze. For comparison, next most heavily shorted stock at the time was Bed, Bath and Beyond at 64%.

    Naked short selling is illegal, but it’s not enforced by the SEC. Normally, even if the hedge fund was caught in a short squeeze, it’s losses would have been manageable. In this case short was 3-4 times higher than the volume of available stock, as some stock is held and not available on the market.

    So I think that this situation will be less consequential for regulation than vlade implies. It was made possible only due to the extreme nature of the short and we can see that similar plays on other heavily shorted stocks, like AMC, Blackberry, Nokia, have not produced the same effect, mainly because the short on those stocks is well below 100%.

    1. lyman alpha blob

      This has been one of my big questions in all this. It sure seems like this was naked shorting by the hedge fund. Someone (maybe vlade?) tried to explain a few days ago why it wasn’t really naked short selling and not really a problem, but I didn’t understand the explanation.

      Looking at it simply, if there is a float of 100 shares outstanding, I’ve shorted 140 shares, and I must buy shares to close out my position, how do I buy 140 when only 100 exist?

      1. vlade

        Comment in moderation limbo, so here goes Mat Levinne:
        “There are 100 shares. A owns 90 of them, B owns 10. A lends her 90 shares to C, who shorts them all to D. Now A owns 90 shares, B owns 10 and D owns 90—there are 100 shares outstanding, but 190 shares show up on ownership lists. (The accounts balance because C owes 90 shares to A, giving C, in a sense, negative 90 shares.) Short interest is 90 shares out of 100 outstanding. Now D lends her 90 shares to E, who shorts them all to F. Now A owns 90, B 10, D 90 and F 90, for a total of 280 shares. Short interest is 180 shares out of 100 outstanding. No problem! No big deal! You can just keep re-borrowing the shares. F can lend them to G! It’s fine.”

        1. vlade

          I’ll just add to the above, that in this example, there’s 100 shares outstanding, 180 shares shorted and 280 shares owned.

          Each sale requires a buy, which means that for every share sold short, a new synthetic, long position is created.

        2. lyman alpha blob

          “There are 100 shares. A owns 90 of them, B owns 10. A lends her 90 shares to C, who shorts them all to D. Now A owns 90 shares, B owns 10 and D owns 90—there are 100 shares outstanding, but 190 shares show up on ownership lists.

          But if A lends her shares to C, she does not own them anymore, because C sells them immediately to D to do the short, no? So the way I’m looking at it, B owns 10 and D owns 90. And then A basically has a promissory note from C to give the shares back someday. C then must buy 90 shares to close out the position at some later date. If they buy them from D again, we’re back to square one with A owning 90 and B owning 10.

          What am I missing here? It seems like if what you described is the case, then there really is no such thing as a naked short. I guess that’s where this ‘synthetic’ idea comes in?

          1. vlade

            In the register, she doesn’t own it, but she is still entitled to all benefits the share provides (dividends etc). And, if she sells it, the borrower is automatically required to make good on it immediately *)

            Shares are fungible. That is, people don’t care whether they own share #1237 or #54678.

            A naked short is when you sell a share, but do not have anything to sell. Remember, shares settle at T+2 (i.e. in two business days from the trade). So if you don’t get a share by T+2, the settlemetn fails,and you technically executed a naked short.

            *) this is actually a second short’s nightmare (outside of the short squeeze), when people who they borrowed the shares from start selling-en-masse and calling their loans back

            1. lyman alpha blob

              So you are saying that a person loaning their shares to a short seller who then sells the shares can still sell the shares they’ve loaned out even though those shares have technically already been sold (it made my head hurt a little just typing that)? And if she is entitled to benefits even though she doesn’t technically own the shares on the register, it would seem that there are two people now entitled to benefits on the same shares somehow.

              I do get the whole fungibility thing in general, but what’s mind boggling to me is how both ends of these types of trades get matched in fractions of a second all the time. Even before HFT was a thing, that was the case – EF Hutton may not have executed trades in milliseconds when clients called them in, but they didn’t sit around for hours either. And as you say, sometimes one end isn’t actually settled, even if executed.

              Still not sure I’m grokking why the GME situation definitely is not naked shorting. It would probably make a lot more sense if I actually tried taking out a short position and then took a look at how my brokerage statement read, but I don’t think I want to learn the lesson the hard way just yet, so I will ponder it some more instead ;) Thanks again for the response.

              1. vlade

                naked shorting is found quickly, because the fail show in T+2.

                It’s actually fairly easy to verify it’s not naked shorting. If you naked-short, because on T+2 you’re told “put up or shut up”, you’d have to roll your naked short position at least every two days.
                – the outstanding short was >100%. Rolling that over two days in naked shorts would mean delivery fails that are in high tens of percents of the float. Even if only a few tens of percents of the shorts were naked, it would still mean rolling high single percents at least
                – something like that would be very very visible in the numbers.

                If a number of fail-to-deliver is correctly reported, and fails are cured quickly (which I believe they are, either by delivery or not settling the money), I do not believe it’s possible to have a large, long running position using naked shorts, because the larges possible naked-short position is then the sum of fails over the last two days.

                1. x

                  Here is a letter that someone from WSB sent the SEC a month ago:

                  To whom it may concern,

                  This letter serves to bring the SEC’s attention to suspected illegal activity in GameStop Corporation’s (ticker GME) trading. As a shareholder in GME, I have concerns about illegal naked short selling and increasing failure-to-deliver rates in the month of December 2020 through present day. GME has consistently appeared on the NYSE Threshold Security list for the last 18 trading days. In order to appear on the threshold list, a stock has to have 0.05% of outstanding shares fail-to-deliver, for GameStop this amounts to roughly 350,000 shares. GME’s failure to-delivery rates have exceed this amount on most trading days in December 2020*.* Furthermore, on at least three trading days in December, the total number of shares failed-to-deliver exceeded 1 million*. Below is a summary of trading days in December which had exceptionally high failures-to-deliver:*

                  12/1: 91,971 @ $16.56

                  12/2: 1,061,397 @ $15.80

                  12/3: 1,787,191 @ $16.58

                  12/4: 999,475 @ $16.12

                  12/7: 1,002,379 @ $16.90

                  12/8: 872,292 @ $16.35

                  12/9: 721,361 @ $16.94

                  12/10: 605,975 @ $13.66

                  12/11: 880,063 @ $14.12

                  12/14: 284,296 @ $13.31

                  Given the data presented above, I request the SEC to further investigate suspected illegal naked short-selling in GME, particularly as it concerns Melvin Capital, who holds a substantial short position in the Company.

                  https://www.reddit.com/r/wallstreetbets/comments/kr98ym/gme_gang_we_need_to_complain_about_naked_short/

    2. vlade

      Irrelevant.

      Naked short is a short where you sell a share that you do not have, which means you will fail to deliver it when you’re actually shorting. It’s illegal, and no short shop ever could build its strategy on it.

      The size of the short position is irrelevant too. I can create _any_ short position I wish, as long as there’s stock to be borrowed.

      Assume a company has a single share, held by A. I borrow the share, and sell it to B. I borrow the share from B, and sell it to C. Voila, I created 300% short interest, no naked selling all perfectly legal.

      In fact, what now would cause me a problem is if any of A or B guys tried to _sell_, because then I’d have to go and buy a share from C at whatever price C asks for.

      Naked selling not enforced by SEC – evidence, please? There are numerous very valid reasons for “fail-to-deliver” failures in the market. Sure, some of those will be used by uncrupulous. But again, and self-proclaimed short shop doing naked selling constantly would be beyond idiotic. Why would someone spend tons of time and money on research to have it all blown up on a blantantly illegal move? That’s Qanon type of conspiracy, sorry.

    3. JTMcPhee

      Seems there is a lot of stuff that the SEC does not “enforce.” Thinking of the young SEC guys and gals who went to examine Madoff’s business activities, and hit him up for a job instead of the other thing. The corruption runs deep:
      https://legaltimes.typepad.com/blt/2011/08/sec-official-bungles-madoff-probe-then-wins-agency-award.html

      When stuff is this complicated, with a guarantee of a federal bailout and no consequences for really bad outcomes for the mopery, why, I ask purely rhetorically, is crap like the financialized millstone around the political economy’s neck allowed to persist and spread the infection?

      Is it a revolving door, or just a foamed runway? Or greased skids?

      What possible utility for a healthy economy is there in any of this?

      1. Yves Smith Post author

        In fairness, Congress has worked hard to hobble the SEC. It is the only financial regulator that is subject to Congressional appropriations. All other agencies live on their fees and fined. Arthur Levitt, appointed by Clinton and the longest-serving SEC chairman, only wanted to protect retail investors. He was of the view that the big boys could take care of themselves. Even with narrow objectives, Levitt ran into fierce opposition and regular threats of budget cuts from Congress, particularly from Joe Lieberman, the Senator from Hedgistan.

      2. vlade

        TBH, the irony of this is that
        – their target – the shorts like Lemon – are arguably some of the few bits that actually have a social value. Because people like Lemon was looking for frauds (or, in case of GME, a company where it’s due-by date is gone). And that do not get any of the guarantees, govt bailouts etc.
        – the parts which make money by churning waters, profiting from volatility and more trading etc. are the parts that made money here

        Which is why Yves and I keep saying it’s not a middle finger to WS.

        The best simile I can came with here (thanks to some response of NC readers) is of a bunch of amateur poker players joining a tournament in a casino. They get a good hand (and a few pro tips), and with some other pros gang on a few guys they don’t like (because he looked at me weird!). In the end, some of them make good money, some of them lose all money (but it’s worth it, we got those guys!), and the remaining pros make a killing.

        Then the amateurs file out boasting how they ruined the casino, which in the background still clings and hums, with the owners counting the profits of the tournament and trying to figure out how to arrange the same again.

  14. Gavin

    It’s worse than that because Melvin was assuredly using leverage to place their short bet.. Assuming only 10:1 leverage and GME starting at $20 and Melvin’s initial investment of $10:
    $10 initial times 10 leverage = $100 used to buy and immediately sell 5 shares of GME at $20
    Each share ramped from 20 to say 350 for a loss of 330 per share. 330 * 5 = $1650 lost per $10 initially invested if levered up 10x. Juicing the profits indeed..

    And we may never learn the inner workings of how many times Melvin took the $100 cash-in-hand from the first 5 shares and used that $100 to lever up another 10x to short (1000/20 = ) 50 more shares..

    So in this quick thought experiment the initial investment of $10 has shorted 55 GME shares for a total liability due last Friday [when per the short contract they had to buy GME at whatever price the market said] of $18,150. And that’s only assuming 10:1 leverage.. imagine the bleeding if they used more than that.

    And now imagine most Wall Street hedge funds doing the same every day… I’m shocked there’s gambling in this casino!

  15. meadows

    I’m nearly 70 and have avoided investing in stocks, probably to my family’s detriment financially but I just have a low tolerance for volatility and complexity… Municipal Bonds, on the other hand…. I feel like I am helping build schools, water systems, sewer systems…. you know, Real Stuff.

    Even if I had the stomach and willpower to have participated in and benefitted from this messy trading, how would I have contributed in any way to a socially beneficial investment?

    But when I turn on my potable water, flush my toilet, walk my grandson to school (recently renovated w/bonds) ….. sorry, I need the tangible.

  16. Deschain

    This is all good, but I think it ignores the elephant in the room that the only reason this was able to happen in the first place is that there is virtually no liquidity in the stock market right now. Lots of stocks are moving wildly, including those of highly stable businesses that have not been targeted by WSB/RH. Just for example, Disney is +4% today on no news. I remember (not all that long ago) when it was rare for DIS to move 4% on an earnings print.

    In a normal market, this type of short squeeze would have been killed in the cradle.

    1. Mikel

      The other elephant in the room are the brokers all over the world who are restricting the exact same stocks as RH.
      That was called a liquidity issue – not targeting….
      So are there brokers all over the world having “liquidity issues’?

      1. lyman alpha blob

        Here’s a stab at an explanation, since I was wondering the same.

        My guess is because the traders were buying in large volumes on margin, and Robinhood isn’t exactly as well heeled as bigger brokerage firms.

        For the purpose of the example let’s assume all trades are long ‘buy’ positions. So say for example Robinhood (RH) has $1billion cash of its own on hand and normally does $500 mil in trades per day for its customers. Not really a problem there. But let’s suppose that trades suddenly spike to $5 billion per day, and $4 million of that is margin buying, meaning the retail investors are borrowing from the broker when they place their orders. So RH now needs to buy $5 billion worth of stock to fulfill its customers orders but it only has $1 billion of its own money and $1 billion from the investors’ accounts, leaving it $3 billion short. And not only that, but the retail investors whose orders RH is trying to fill have taken on a very shaky position (in the case of GME at least), meaning they are highly likely to take a loss and therefore won’t be able to make good on what they borrowed from RH. So the counterparty who is selling the $5 billion to RH sees a large potential shortfall and demands that RH come up with the rest of the cash before settling any more trades. In other words, the counterparty seller won’t allow the brokerage to trade on that high of a margin, and essentially do a margin call on RH. RH then needs to stop trading until they can raise enough funds to cover their customers’ orders. That’s the ‘liquidity issue’ – not enough people wanting to trade actually have any real cash to pony up.

      2. vlade

        Yes.

        Because DTCC raised margin requirements for everyone, equally.

        You either had the cash and met the margin, or didn’t and stopped trading (to get the cash or get the margin down by settlement actually occuring).

        This is exactly the case of “same rules for everyone, DTCC’s rules”.

        1. John Anthony La Pietra

          Sounds almost like Anatole France’s take about how “The law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread.”

          But there are differences — notably, to my eye at least and if I’m following properly, that here folks are being forbidden to go on doing something they did voluntarily. Unless, perhaps, there was someone like CalPers doing the investing for a bunch of those folks.

    2. Mikel

      There is a broker from down under that begins with an “S”…
      And a broker in Europe/UK that begins with an “R”…

      These are examples…

    3. Mikel

      “Just for example, Disney is +4% today on no news. I remember (not all that long ago) when it was rare for DIS to move 4% on an earnings print.”

      Not the only wild jump.
      For the past year, I’ve noticed the wild jumps in the overall market happen whenever there is something happening that is not good. I’ve become thinking of them as pacifier bumps….or some say “climbing the wall of worry.”

      This is followed by the jumps being explained by the good news ahead. That then turns into the good news that is still ahead. Followed by the good news that is still ahead…so keep buying, wink-wink.

    4. vlade

      Sorry, you can’t mean it. GME’s float is turned on a day, and you call that that “no liquidity”? Even 200 day moving average is like 1/6th of the total float, and the free float is much smaller (because IIRC there are at least two large, like 10%+ holders).

      Evidence please in hard numbers (volume vs free float ratios).

  17. Susan the other

    Maybe a new rule for the SEC would be to force all publicly traded companies to keep their excess cash hoard in a government insured escrow account for the benefit of the current shareholders. Protect it somehow from any and all raiders, including the company’s own executives. It might be a good thing to itemize all the persons of interest – that is all the common stock holders as well as the principals involved. What are the chances the SEC will do this sort of thing? It would make the public stock market behave in the interest of the… public. Maybe what we need is to have the IRS require these security measures. Or are they already in place but not enforced? That would (maybe) prevent a lot of the private equity abuses too.

  18. Harry

    One quibble. It doesn’t really matter whether the trade is done by shorters trading outright or by option marketmakers. An amount of delta is an amount of delta and who assumes it is irrelevant (apart from in allocating losses). So while professional shorts are always interested in doing so via the lowest risk route, lowest cost route, Im not sure the market is gonna make this easier for them. Of course, I probably misread you, and you might well have been arguing that, at the margin, shorter will choose to buy puts rather than take the underlying short because of an increase in squeeze and business risk. Agreed. However option market makers will face exactly the same risk. So they will raise their prices accordingly.

    Re the SEC and market manipulation, there is a lot written already. I suspect this is a question of the will and the resources. The SEC just wont be able to pursue all those cases. There are certainly messages which look manipulative, although saying you think there is a chance to execute a short squeeze, is not manipulative in itself. “He that sells what isnt his’n, must buy it back or go to pris’n”. And selling 140% of the float would definitely attract my attention. Who does that?

    So I dont see a problem saying “$GME could short squeeze cos there is a huge short out there. Wouldnt it be amazing if a bunch of us bought the stock and forced a squeeze, just like the hedge funds?”. But there are definitely problems with saying, “I suggest you buy 20,000 calls at this price at 2pm, and I will coordinate my buying to coincide with yours and yours and yours. If we execute simultaneously the option market makers will be left driving the price up for us to hedge their mispriced gamma”.

    FWLIW. I bought a few 70 strike, 5 day puts at 5 bucks. Extortionate but it wasnt tough to imagine it might sell off when option settlement happened. How would all the Gamestoppers fund their call exercises?

    1. vlade

      A comment either gone, or in a moderation limbo, but an option will never have delta of one or -1 (it will limit to it though). Technically, a call delta = N(something or other), where N is a standard cumulative distribution function which limits to +1/-1 for +inf/-inf.

      An ATM call option usually will have delta between 0.3-0.6 for sort of “normal” parameters.

      Assume it’s -0.3. Then if shorter shorted -100 shares, his delta would be -100. An option maker would hedge the position with a short of 30, not 100.

      1. harry

        Absolutely. However, by buying the option you have simply transferred the short liquidity and short convexity position to the option market maker. You might argue he/she is better suited for dealing with it but i doubt that. After all, the marketmaker is probably agnostic about the underlying trade.

        As for the delta, i suppose you could argue that the client only wanted a 100 nominal position so buying atmf puts, will get them there, but only require 50% of the delta. But for the market maker that’s only the initial hedge. As it goes in the money it will tend to delta 100%. I just don’t think assuming a significant reduction in net delta is a sensible approach. I think in practice there is close to no reduction in delta employed. If it goes in it will tend to 100%. If it goes otm it will tend to zero. The client might not cut as quick cos the cut is “automated”, so to speak. For the clients p&l to be the same if they are right they well need a slightly bigger nominal position cos they have to pay for the option.

        The only real difference is the transfer of liquidity and convexity/gamma risk. And this is kind of intuitive if you think about options in terms of the equivalent hedge. No free lunches.

        Anyway, thats my 2 cents on it, fwliw.

        Regards

        1. vlade

          Yes, of course the hedge can get to be delta-equivalent. But the initial position is smaller, and more importantly, as the price moves against the short, the broker will liquidate it faster.

          GME @70 would have little to no broker delta, while the shorts might well be holding on for their dear life (as seemed to be the case with GME where the open short postion even last week was still quite high).

          Hence my argument that if outright shorting was _entirely_ replaced by the puts, the short squeeze would very likely be faster – but also much smaller. That is, unless most of the sold puts were already deeply in the money, with a delta similar to the outright position.

          But assuming those puts were sold as ATM or close to ATM, it would be very hard to argue that it was the shorters who were driving the price down (even indirectly).

          1. Harry

            1) Not sure. I mean yes, but its just a smaller initial position taken by clients (in delta). Why assume they want less initial delta? Revealed preference?

            2) Im hoping that changes. They were quite cheap to start with. But you know, high enough vol and everything has some delta.

            3) Maybe. That speed might actually exaggerate the scale of move.

            4) Some people (like me) will argue anything.

            1. vlade

              Re 1) The shorters don’t hold the option for a short term purposes, so they don’t care about the option delta that much at the inception. The idea isn’t to sell the option for pennies on the option price, the idea is to cash out properly, with the option delta being ~1. Or, put it differently – they don’t care what the option delta is initially (except indirectly), they care what the S-K is close to expiry, as that drives whether/how they roll the position.

              2) indeed that with a high vol everything has some delta. in the GME case, you might actually see a funny behaviour where the market makers who might have no delta at 70 will have delta at 400 – because at that level, selling 1 share is way better than selling at 100 (this is the weird thing with BS).

              3) TBH, it’s hard to say. I could have overlooked some detail that would make it worse, this is my first approximation.

              4) so will I ;)

  19. lyman alpha blob

    Most option sellers will not run a naked option position. All major option sellers will delta-hedge their positions, meaning they buy/sell stock to limit their risk from the option. Put options need to sell the underlying stock, but because of their probabilistic nature, the required amout of stock to sell depends on the current stock price, option strike, and time to expiry. Simplified, the amout of stock needed to be sold increases as the option gets more into the money (that is, it would be profitable to exercise it). An at-the-money option, where the current price is the same as the strike, would have to sell a fraction of the share to hedge.

    I have a question on the above as to the why of it all, unrelated to the particular Gamestop issue. Years ago I spoke with a broker friend who explained some of the trading strategies he used for well heeled investors. One thing he would do is advise owners of Microsoft stock who had owned the stock for years to sell call options on it, especially if they thought the stock price was unlikely to rise much in the near future. So if the stock was currently at 100 and they had originally purchased it for 50, they could sell an option with a 105 strike price for $2 (or $200 for the contract). If the stock doesn’t go up, they pocket the $200 and keep the shares too. If the stock does go up to 110 for example and the option buyer exercises the contract, the seller of the call must sell the underlying stock at 105 per share, plus they already got $2 per share for the option contract, basically gaining $57/share over the initial purchase price. Had they sold the stock outright, they would have made $60/share, but they still make a lot of money. That’s a covered call from what I understand, and if you sell a contract on a stock that has already gone up enough already since purchase, there is no way to lose money overall – you only lose some potential gain.

    Now let’s use the same figures, but for a selling a naked call. In that case, if the option is exercised, then the seller of the call is still the one responsible for filling the order. Is that correct? So if the stock sits at 100/share for a while after the options contract is issued, then the seller of the call might not bother to buy the underlying stock. But if the stock moves to 104, then the call seller would buy the underlying stock as a hedge. Then if the price goes to 108 and the buyer exercises the option at the 105 strike price, the options seller makes $100 on the stock when the option is exercised (bought at 104, sold at 105) and also pockets the $200 from the initial contract, resulting in a profit. If the call seller did not own the underlying stock already when the option was exercised, they would have to buy stock at 108 and sell it back to the call buyer at 105, resulting in a net loss of $100 ($200 for the original sale less the $300 loss on the shares). So the more in the money an option gets, the more stock the options seller would want to buy.

    Do I have that right? And sorry for the lengthy question, but I find it easier to understand these strategies when real numbers are involved.

    1. vlade

      You have the intuition about this almost right. It’s entirely right for the covered position.

      For the “naked” call, it’s somewhat different. This is what a retail investor might do. The problem with what you describe is that if you buy the stock at 104, if then the stock moves to 100, you lose 400 on the stock + 200 on the premia, so the stock ends where it started but you’re 200 out.

      The brokers/market makers do something that’s a bit more sophisticade (although not necessarily always more right). Say we do a call for 100, with the strike 100. Instead of buying 100 immediately to create a covered call, they buy just 30. When the price goes to 105, they buy another 10, etc. etc and say at 120 they might get the 100 shares – but if the price starts going down, they start selling the shares.

      The numbers above are entirely invented and wrong, but you get the idea. The number of shares they buy/sell is decide by a number called delta that I talked about, and the procedure is called delta hedging, because they are trying to keep the position delta (option + stock) close to 0. How close to 0 depends on their risk department, and is basically where an experienced market maker can make his money.

      1. lyman alpha blob

        Thanks, that makes perfect sense. I haven’t bought individual stocks in decades now, and never options, so while all the options strategies make sense, I’ve never gotten to the point where they feel intuitive, and I always need to think it through quite a bit.

        If we’re going to have capitalism, I can sort of see a justification for stock options, but I can also see how a smart trader might be able to rip people’s face off without too much difficulty. And once you get to the more exotic derivatives like rate swaps, etc I see why they exist, but I’m not convinced at all that they should.

  20. Matthew G. Saroff

    I know that naked shorts have been illegal for over a decade.

    How much of this, and for that matter how much of the total short market, is illegal, or loophole based, naked shorts?

  21. oliverks

    Could a transaction tax really work?

    It seems like a nice idea, but you feel the finance guys would quickly come up with some work around, where they trade among themselves without appearing to shift the assets at all.

    It would reduce trading among the small retail investors, which might not be a bad thing.

    1. Matthew G. Saroff

      In its original incarnation the transaction tax. aka the Tobin Tax, was to be applied to foreign currency exchanges.

      James Tobin noted that it would likely miss the street trades of currency between individuals, but that was unimportant, because for any large transaction, there are only a dozen or so institutions that can execute the clearing/settlement process, which 99+% of the transactions in dollar value must do.

      As an aside, frog marching banksters out of their offices in handcuffs if they try to evade the taxes should remain a part of the equation.

  22. Boshko

    re: denial of price discovery

    1) I appreciate the introduction of the new concept. Thank you!

    2) I see how a coordinated DoPD “attack” is a new phenomenon, but only in the sense that coordination is a probability function and in the case of GME the probability of success became high. But isn’t it true, then, that any flash crash we’ve observed is a DoPD attack? In this case coordination is behind the veil of an algorithm, or several of them.

    3) The example of commodity markets threatened under a DoPD attack highlights the broader macro risks. But the trade volume in oil is so high that I don’t see a DoPD attack being successful in such a market. And suppose it was. How long would an attack have to be successful before utility prices, gas prices, etc are affected?

    1. vlade

      2) it is (flash crash). But most of those were so far from fairly concentrated sources, so relatively traceable. The novel thing on this IMO is tha it’s a distributed one, without the ability to trace. Also, similarly to DDoS, the only way you find it about it is when it’s actually happening, which is clearly late.

      3) the point in commodity would be more of a price volatility than an actualy price being too high etc. It would mean more hedging but at higher costs IMO. Which means higher operational costs.

  23. No Truck with Fryers

    So the frying pan/fire issue is whether the stock exchange is a market priced up according to negative perception of solvency or positive to earnings/innovation OR by mark to market* but for portfolios in their holdings, with soft touch regulation waved through because it’s in so many disparate interests you could, almost, generalise, that, and the pensions bail-in/perma-funding of some indexes isn’t really disputed, I think* but the move to encourage individualism (investing) is apparent unless you’ve found a nice spot in the sun, then someone needs to steady the wheel and earn a tidy income, randomness and irregularity seems to be a law for the large numbers but I digress.

    Do we want to reward opportunism and syndicate (cash) or memory and pattern recognition (chequebook), or is the, admittedly complex, hybrid the best way for everyone to get a fair crack of the whip?

    *Deeper waters for this naked capitalist so I will read Yves on Warren’s letter but dude, link?(!)

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