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
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).