[Deribit] The Game Stop Saga – How did retail investors use options to short-squeeze billion-dollar hedge funds?

Today U.S. Congress held a hearing on Game Stop frenzy to understand the current state of the market and how the unprecedented retail buying surge caused a 1,600% price increase in stock. The chairman of Interactive Brokers – Thomas Peterffy, even said that the Game Stop short squeeze brought us dangerously close to the entire system’s collapse. Yet, the public seems to be completely unaware of that. Now, as Congress is debating whether more regulation is needed, let’s look back at what happened and the power of call options.

The analysis is written by 路有所思 and translated by Deribit.

In January, Covid-19 was no longer the most discussed topic, as a new bomb dropped on the financial markets. GameStop became the hottest topic, covered in all news across the world. In an unprecedented way, retail investors in the U.S. pushed GameStop shares (ticker symbol: GME) into the stratosphere, crippling billion-dollar hedge funds! As retail investors joined forces to pump up GME stock, not only did its price skyrocket to record levels, but major hedge funds in Wall Street were also squeezed out of their short positions.

1. The Turning Point of the Junk Stock 

GME, a video game retailer, had been on a downward spiral for years. Its stock was reduced to a junk stock as its price fell to $3 last March. However, on January 11, that changed. Ryan Cohen, the co-founder and former CEO of e-commerce company Chewy, bought a large number of GME stocks, becoming the company’s second-largest shareholder.

Who is Ryan Cohen? In 2011, at the age of 25, he founded Chewy, a vertical e-commerce retailer of pet food and other pet-related products. By 2016, Chewy had already grown into the largest online pet supplies retailer in the U.S. And one year later, it got acquired by PetSmart – the largest pet speciality retail chain in the U.S. at a valuation of $3.35 billion, making it the biggest e-commerce acquisition in history. Following the sale of Chewy, Ryan bought 6.2 million shares of Apple, becoming its largest individual shareholder.

Last November, this active investor wrote a stern letter to GameStop’s board of directors, urging them to accelerate strategic transformation as soon as possible in order to develop the company into the Amazon of the gaming segment. What happened in between remains a mystery. But on January 11 this year, Ryan gained a board seat at GameStop along with two allies.

Based on Ryan’s success in Chewy, stock investors, Redditors, and fans had faith in Ryan’s ability to develop this sluggish brick-and-mortar video game store into the Netflix and Amazon of the gaming segment. Such faith led to the subsequently skyrocketing prices and the long-short game.

2. Citron Covered Most of its GameStop Shorts at a 100% Loss 

On January 12, GME stock price was still at its normal level. Yet, one day later, it surged, and the upward trend continued. On January 19, when GME stock price increased to $40, Citron Capital could no longer stay silent. Maybe because of their short positions, they decided to lecture retail investors on “why GameStop stock is worth only $20”.

Surprisingly, not only did retail investors refuse to listen, they went in exactly the opposite direction. An army of retail investors led by WallStreetBets (WSB) started to instigate more Redditors (Reddit is a famous forum website in the U.S.) to long GME. They stirred up Redditors’ sentiments by saying that as long as they were of one mind, they would succeed in forcing short-sellers to buy back their shares, driving up the stock price, and making substantial profits. Under this instigation, GME stock price further increased by $25 in a matter of days.

The GameStop Short Squeeze can be seen as an organised large-scale “financial violence”. Andrew Left, editor of Citron Research and managing director of Citron Capital, publicly announced that he would no longer comment on GameStop. He claimed that the crazy Redditors had started to harass his family and that he would turn over relevant evidence to the SEC.

3. The Options Market is the Main Battlefield 

After Citron Research released the announcement, retail investors started to rush into the market like sardines, pushing GME stock price to nearly $75 during that day.

In theory, there’s no limit on how much money you can lose on short-selling stocks.

Different from previous short squeezes, GME retail investors bought a lot of call options in addition to buying a large number of stocks to push up the stock price. As a result, the trading volume of GME options in recent days far exceeded the total trading volume last year.

The continuously increasing stock price forced a large number of market makers with negative gamma to aggressively hedge by buying more stocks, which formed a positive feedback loop that would only cause them to suffer greater losses. The crazy retail investors, the market makers who needed to buy stocks to hedge the negative gamma, and the limited liquidity plus the soaring borrow rate formed three terrible strikes.

On January 20, the highest strike prices of GME options with any expiration date were $60. The price of the $60 call expiring on January 29, 2021, was only around $10. These retail investors deliberately chose to buy deep out of the money options (with the biggest leverage). For example, a retail trader with only $6,000 in his account can only buy 100 underlying stocks. However, if he buys 600 options contracts, he is able to leverage 60,000 stocks (600*100; an individual stock option contract represents 100 stocks, which means that buying an option contract equals buying the option of 100 stocks).

4. Why is the Options Market the Main Battlefield? 

Due to the buying frenzy, the open interest of the $60 call option became the largest in the market. Normally, this would not have a huge impact if there were no major fluctuations in the stock market. However, the volatility of over 50% caused by the GameStop stock frenzy made life difficult for the market makers.

Moreover, the closing price on January 20 was $65, a rare phenomenon when the stock price is above the strike price of all options. This is because the market makers with negative gamma have no means of hedging, as there is no limit to the price increase of stock. If the stock price jumped significantly next Monday, the negative gamma exposure held by market makers would be big enough to render a medium-sized market maker insolvent.

Melvin Capital was the first victim of this short squeeze. It suffered a significant loss on short-selling stocks. As a result, it had to raise a $2.75 bailout from Citadel and Point72 Asset Management. At the beginning of this year, Melvin Capital had $12.5 billion in assets with GME stocks being one of its many short positions. However, the significant loss caused by short-selling GME stocks decreased its asset value by almost 30% within the first three weeks of January.

5. The Persistent Short Squeeze 

It was thought that the short squeeze would come to an end when retail investors pushed GME stock price to $65, giving Melvin Capital a heavy blow. What caught the whole market by surprise was that the game had just begun.

Let’s go back to the GME battlefield. On Friday (January 25), exchanges added many high strike prices with reference to the closing prices. The highest strike increased from $60 to $115. The situation got better for market makers as now hey had more opportunities for hedging.

However, the opening price of GME stock jumped directly to $95, 50% higher than the closing price on the previous Friday. This price jump came as a heavy punch to market makers. This is due to negative gamma exposure, where gap risk is the biggest nightmare. Gap risk would not only cause massive losses to market makers but would also increase negative delta exposure by a large margin, forcing market makers to continue buying stocks to hedge.

Yet, in the meantime, retail investors had already started a new round of call buying frenzy. The $115 call option became the new target this time.

WallStreetBets continued to support retail investors to long GME. “Let’s crash the short-sellers! F**k the fundamentals!” Why was WallStreetBets so confident? Because the GME’s short interest not only did not decrease but increased instead!

Apart from sending posts to support traders to long GME, WSB also posted a screenshot of its own account page, showing its followers that they could also earn huge profits as they did. Many retail investors on the Reddit website also posted screenshots of their account pages, showing profits ranging from tens of thousands to millions of dollars. This game took on a flavour of the bitcoin community.

The screenshot below shows the closing price on Tuesday evening, with WSB earning a profit of over $17 million!

Exchanges were also poorly prepared for this duel between retail investors and major hedge funds. One hour after the market opened on January 25, GME stock price surged to $120, exceeding the strike prices of all options once again.

It can be seen from the screenshot below that retail investors’ buying frenzy caused the volume of the $115 call expiring by the end of January to reach 112,000. Despite the market makers’ high quotes for options, the buying enthusiasm of retail investors remained unaffected.

At this point, there was no reason to speak of GME’s options trading. The only thing on the retail investors’ minds was to fully squeeze the short-sellers out of their positions.

6. Marching Into Insanity 

The following day, exchanges added more strike prices, with the highest at $200. The open interest and stock price, together with the more tradable stock options, now offered more leeway for option market makers. Undoubtedly, some retail investors and institutional investors would hope to profit from this ridiculous duel, leading to an increase in the number of options sellers.

In the first half of the duel, the stock price fluctuated between $75 and $100. It might have seemed ridiculous, but the end of this duel was far from over. In the second half, an aggressive push started. And the call option with the highest strike price ($200) remained the target.

By Tuesday, when the closing price was $148, the price of the $200 straddle expiring February 19, 2021, had increased to $150. In other words, market makers were telling retail investors that the straddle would not yield any profit unless GME stock price went below $50 or above $350 on the expiration date (February 19).

7. After-hours Trading on January 26 – Short Sellers Keep Losing Ground 

GME stock price soared from $148 to $214 during the after-hours trading session. This duel between retail investors and institutional investors had just started.

Yet, the price action caught everyone by surprise as the stock price surged further, reaching $375. In just three days, this stock had soared threefold.

On Tuesday (January 26, 2021), the trading volume of GME stock reached $20 billion, exceeding the trading volumes of Apple and Tesla stocks. How could a small brick-and-mortar video game retailer’s stock achieve such good performance? Why did its stock price and trading volume increase so dramatically? Who benefited from this surge? And who got short squeezed out of their positions?

8. Reinforcement From Long Investors 

The heavy-weight support to the long side caught the market by surprise. Chamath Palihapitiya announced that he had bought 50,000 $115 GME calls expiring February 2021, adding a new wave of enthusiasm to the already enthusiastic WSB.

Chamath Palihapitiya is an American venture capitalist. As one of the early employees of Facebook, Chamath had already achieved financial freedom upon leaving FB. Later on, he established his own venture capital firm and achieved impressive success by successively investing in several unicorns!

In addition, Chamath purchased $3 million in bitcoin back in 2012. Later, he bought a lot of Tesla stocks and blatantly opposed Jim Chanos on CNBC. (Jim Chanos is the founder of the hedge fund Kynikos Associates. After short-selling Tesla stock for five years, he closed his stock position and suffered a huge loss. Currently, he only buys puts and is very prudent in short selling.) It can be seen that Chamath had a long-held deep prejudice against short sellers of bitcoin and stocks. And his heavy involvement in many special purpose acquisition companies (SPACs) is also highly controversial.

With the participation of Chamath, an experienced, reputable and rich investor, it was only natural that retail investors went crazy again!

GME stock option was fluctuating between $40 and $45 when he made the purchase. By Wednesday evening, the price of this option had increased fivefold in a matter of 24 hours. In other words, he earned a floating profit of nearly $ 10 million in just one day.

It can be seen from the Delta and Gamma curves in the screenshot below that the $115 call is now deep in the money. Though IV (implied volatility) remains high, Gamma has dropped to a very low level. Therefore, the movement of the call position will be similar to that of the underlying stock.

Apart from Chamath, Elon Musk also joined in stirring up investors’ sentiments. His post on Reddit added fuel to the fire and sent retail investors into a frenzy once again!

Musk is, of course, a veteran in the fight against short sellers (he must have a lot of resentment against short-sellers). He does not necessarily know the ins and outs of the story, nor is he supporting retail investors. Nevertheless, given his playful personality, he knows that his push will make this play even more interesting.

9. Short Sellers Suffered a Crushing Defeat 

On January 25, Melvin Capital received a $2.75 billion bailout from Citadel and Point72. And just as they thought they could finally take a breath, the veterans on WSB gave their “soldiers” a precise target on that day. Right after the opening of the market on Wednesday, GME stock price instantly jumped to $300.

Soon after, CNBC reported the surrender of Melvin Capital, which closed out its short position in GameStop.

Despite this huge success, the WSB community still refused to give up. Redditors suspected the CNBC report to be false because it was simply impossible for Melvin Capital to close out such a large number of positions on January 26 alone.

Apart from suspecting Melvin Capital of feigning surrender, the WSB community also attempted to calculate Melvin Capital’s loss and the time it closed out its positions.

Melvin Capital had $13.1 billion assets under their management (AUM) as of March 2020. Assuming that its AUM remained unchanged, Melvin Capital would have lost 30%, which equals $3.9 billion. During this period, GME stock price increased by $46.95. In other words, for every $12 increase in GME stock price, Melvin Capital would lose $1 billion. So, when GME stock price hits $175, it will be game over for Melvin!

However, as shown in the trading volume screenshot at the beginning of this post and the screenshot below, the trading volume on January 26 was only slightly lower than that on January 22. The daily trading volume nearly reached 180 million stocks, 300% of the shares outstanding (a turnover rate of 3 times). Therefore, in our view, the argument that Melvin Capital was unable to close out its short positions due to the low trading volume on the WSB community is ungrounded.

In addition, BlackRock also closed some of its positions in GME. We can see from the regulatory filings that its holding of GME shares is down by 13.2% after selling a total of 2 million shares. We suspect that BlackRock sold GME stocks through the OTC market instead of exchanges, whereas Melvin Capital might have bought these shares from the OTC market to close their short positions. Therefore, in our view, the news about Melvin Capital closing out its short position in GameStop might not be false like WSB suspected. This is just our guess, of course.

In addition to crushing Wall Street elite, online has been rumouring that some retail investor in China might have also been crushed. On January 25, a retail investor in China posted a screenshot of his account page, showing that he had sold many calls and celebrating his account balance reaching HK$10 million. However, we never heard from him again after GME stock price surged on January 26.

According to our rough estimates, had this investor not closed his positions, selling only 3 GME calls would have resulted in a loss of $2.5 million (HK$ 19 million). And this doesn’t include the loss that would have been incurred by selling calls which also experienced a price surge. Therefore, had he failed to stop loss in time, his positions might have been liquidated by the platform.

Compared to this investor, experienced short-sellers know the craziness of retail investors very well. So, they did not dare to get themselves involved, even though they are familiar with this ridiculous duel. For example, the famous short-seller Marc Cohodes remained an onlooker, tweeting – “Never swim with drowning men!”

10. The Endgame 

WSB’s plan to short squeeze the hedge funds is very elaborate and well-conceived. Every day, there is an analysis of the stock price movements and predictions about the positions of short sellers and market makers. There are also elaborations on how the delta of in-the-money options and out-of-the-money options would change as stock price changes and what influence retail investors’ position adjustments would have on market makers’ positions.

While GME bulls kept supporting each other, the endgame for the GME trade also became a topic of interest. Some people analysed and described the outcome of persisting in (or giving up on) the current path so that investors could make their own choices according to their own situation, GME stock fundamentals, and their predictions of GameStop’s future development.

Despite surging to $375 on January 27, 2021, GME stock price experienced much smaller fluctuations afterwards. In our view, such a turn was attributable to the following reasons:

• With the increase in the stock price, the cost of buying stocks became higher and higher, which meant that fewer and fewer people could afford to buy stocks.
• After several rounds of war, option market makers, which had suffered massive losses, also have accumulated abundant experience. The implied volatility (IV) had surged to an incredibly high level. And as IV gets higher, options become more expensive, and fewer people can afford to buy options. For example, one contract of the $320 call expiring on January 29 cost $10,000. As a result, the trading volume of options declined sharply compared to a few days before.
• Citron and Melvin both surrendered and claimed that they had closed out their short positions. The retail investors’ purpose was to force these hedge funds to close their positions. So, once their purpose was achieved, this game officially turned into one between bulls, and whoever runs faster wins.
• As the expiration date for options approached, the expensive premium made it harder for new game players to earn profits. Other than those who had already earned a huge profit, many traders did not have enough capital to make physical delivery (In other words, those who bought calls would have to buy stocks at the strike price upon expiration of the options.)

By the end of the week, brokers had raised margin requirements for GameStop shares to prevent retail investors from selling positions on a large scale. When the margin for long stock positions is raised to 100%, closing a $300 call costs $30,000 (300*100*100%). This significantly reduces the number of retail investors who are able to buy options to continue their short-squeeze game. Besides this, several brokers also restricted retail investors from opening new positions. This action undoubtedly ignited the anger of retail investors again as institutions were allowed to keep trading in GameStop and the other companies. As retail investors could not continue pumping up the stock price and their need for buying calls decreased, market makers suffered less pressure from holding positions with negative gamma.

January 29 marked the expiration of all the options contracts with a strike price of more than $320. It was the first expiration of out-of-the-money (OTM) calls on a large scale since retail investors started to pump up GME stock on January 13 this year. It’s fair to say that retail investors who joined the party later suffered great losses. This huge blow on a lot of retail investors further undermined their short-squeeze ability. As traders started to unwind their positions and switched to new targets, the stock price fell by 85% in the first week since its ATH. It has been decreasing ever since.