By: Steve Smith
The short squeeze saga continues to dominate not just financial headlines but also moving into the mainstream as Gamestop (GME) shares surged another 150% yesterday, apparently forcing several large hedge funds to close their short positions for large — possibly bankrupt-inducing — losses.
The reason I’m returning to this topic is twofold: Yesterday’s article elicited a ton of emails and the story became a multi-issue touchstone beyond the specific stocks involved.
There are technical and legal questions surrounding what constitutes stock manipulation, why short selling is even allowed, and the market implications debating if this is a sign of euphoria or a bubble. But, the story also has broader implications seemingly capturing the current social mood zeitgeist.
Namely, the growing distrust of institutions and experts — be it political, medical, or financial. The GME phenomenon, which to recap is one of the retail traders gathering en masse on online forums like WallStreetBets to target stocks with unusually high short interest with hopes of making money and inflicting painful losses on hedge funds. Many compare this to other events such as storming the Capitol and the post-financial crisis Occupy Wall Street movement; all part of a broader populist movement where the regular, or ‘little’ guy, feels growing resentment against the ‘elite,’ who increasingly make rules that are self-dealing or feel don’t apply to them.
In this column, I’m sticking with the financial and trading aspects. I’m a huge advocate for people empowering themselves and taking control of their financial well-being. I’ve spent a good portion of my professional career proselytizing for the proper use of options to generate income and build wealth. Indeed, a major aspect of my Options360 service and role in the OptionsAcademy is of education and ‘teaching a man to fish.’
However, I’m concerned that this episode will have negative consequences well beyond ‘it will end badly’ with stocks such as GME and AMC ultimately popping, resulting in newcomers or less responsible retail traders losing money. Many are making money and those that aren’t are or will get an important education.
I think the larger problem isn’t only the gleeful revenge factor of the WallStreetBets/Robinhood crowd of “the pros have been screwing us for years, it’s time to do it to them.” It’s the manner and indeed success that’s been executed — revealing structural market cracks, confirming the perception that the system’s rigged.
There surely will be calls for some sort of regulatory reform such as bans or limits on short-selling, new disclosure rules, and social media platform monitoring. None of these would be good developments.
Many people wrote in asking why short-selling, or the act of selling something you don’t own, is even allowed. Shorting plays a critical role in maintaining market hygiene. At a broad level, short positions can be part of risk management. They can also help to amplify quantitative stockpickers’ skills, by pairing under- and-overvalued stocks — betting on the difference to narrow. The possibility of short-selling also helps keep the market honest by giving some investors an incentive to find companies engaging in accounting or other fraudulent behavior.
A short-selling ban would be a major negative for market health. Rather, what I think we’ll see is a self-correction on the bad actors on both ends of the market. Large hedge funds will restrain using their financial muscle to drive down share prices for fear of a squeeze turning on them, with small unsavory players, especially in the newsletter business needing to think twice before building a small-cap stock short position and issuing a bearish alert.
One thing I know for sure is that no one’s going to take a big short position and publicly broadcast it as Bill Ackman did with Herbalife (HLF) a few years ago. It turned into one of the worst trades of his life as other hedge funds lined up to squeeze him out.
I’ll also guess institutions will ask for rule changes regarding what they need to disclose in terms of positions in their quarterly filings. I’m not sure how I feel about this. On one hand, you want transparency. On the other, why does someone, with even larger funds, need to show their hand while the game’s going on?
Another issue needing to be addressed is the options market role. I’ve discussed how selling options creates gamma risk, which can lead to self-fulfilling price movement. However, the buying out-of-the-money calls are being used for the tail-wagging-the-dog through highly leveraged positions. The exchanges probably need to reexamine how and when they list new strike prices.
Sometimes, new higher strikes won’t come until a stock moves well past that level. In GME’s case, they were quick to list $200 strike calls just 3 days before expiration when the stock was still $150. Over 100,000 of those $200 strike calls were traded yesterday — simply astounding. Additionally, they might consider imposing position limits so the notional value represented by the options can’t grow 20x or more of the underlying companies’ market capitalization.
Overall, I can appreciate some of the schadenfreude and am enjoying the spectacle of this situation. But, as I’ve stated many times in this column, I and the Options360 Service stick to our knitting which is finding solid, and rational setups and grinding out consistent profits.