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- Steve Sosnick is the chief strategist of Interactive Brokers and the chief trader of its Timber Hill business unit.
- Sosnick breaks down the Reddit traders set up for GameStop.
- He also explained how the parabolic movements of these memes stocks could permanently alter the markets.
- Visit the Business Insider homepage for more stories.
The markets were possessed by the GameStop mania last week, and it was hard not to pay attention.
The physical video game retailer that was once left for dead in the coronavirus-induced lockdown has jumped more than 1,300% in the past month.
GameStop’s stratospheric rally, driven primarily by Reddit traders WallStreetBets, has rocked hedge funds such as Melvin Capital and Citron Research. According to data provider Ortex, GameStop’s short sellers lost around $ 19 billion in 2021.
And that’s not all.
After Robinhood joined other major brokerages on Thursday to restrict trading in GameStop, which would have caused the stock to drop as much as 60% before resuming its rally, the Securities and Exchange Commission said it ” closely monitored and assessed the extreme price volatility “of these so-called meme stocks. Congressional Democrats have prepared for two hearings on Wall Street practices and online commerce.
So how did it all happen? While Reddit traders have often been described as unsophisticated and inexperienced youngsters trading stimulus checks in their parents’ basement, the strategy they employed – a short push that ultimately turned into a Gamma pressure – is actually quite complex.
To understand how these small retail investors outsmarted hedge fund managers, Insider spoke with Steve Sosnick, chief strategist at Interactive Brokers and chief trader at Timber Hill, the company’s trading division.
A veteran trader with over three decades of options and stock market experience, Sosnick experiences short press and gamma pressure when he sees one.
What is a short press?
To sell a stock, investors must borrow stocks from their brokers. Then they will continue to sell the shares to others in the market in the hope that the shares will drop.
Once that happens, these investors hope to buy back the shares for less than what they paid to borrow the shares in order to pocket the difference when they return the shares to their broker. This is a classic “sell high buy low” short selling strategy.
The process may seem harmless enough, but the risk is that investors will have to repurchase those stocks at some point, regardless of the price. Even if they choose not to redeem those shares immediately, they will need to deposit enough money in their accounts because the broker is lending the shares on a collateral basis and they want collateral for their loan.
This is why, as stocks continue to rise, brokers will ask for more money from short sellers.
Sosnick adds that another pitfall for a short seller is that if the lender of the stock sells, then the short seller will have to go find new stocks to borrow. If the short seller cannot find new stocks to borrow, they should go out and buy that stock whether they like it or not.
“These two items are what contributed to a short tightening. So either the stock becomes too difficult or too expensive to borrow, or the stock starts to rise too quickly,” he said. “Then the short sellers are forced to cover their shorts. And if that happens quickly enough, it creates a feedback loop and becomes a self-fulfilling prophecy.”
And that’s how the GameStop saga began.
Reddit traders jumped on GameStop because it was one of the best-selling stocks on Wall Street. At one point, the stock’s short interest was 144% of its shares available for trading.
The massive short interest in GameStop meant that retail traders could collectively buy stocks, push its stock price higher, and force GameStop’s short sellers to buy back stocks in order to limit their losses.
That’s exactly what happened, except the losses were so huge that Citron Research, for example, had to hedge the majority of its GameStop shorts with a 100% loss.
What is gamma compression?
The short squeeze on GameStop turned into gamma squeeze when traders at Reddit started using call options, a leveraged way of betting that stocks will rise.
To understand what gamma is, investors need to look at Delta, which is a measure of how much you can expect the option to move for a given movement in the underlying stock.
For each call option buyer, there is a call option seller or broker, who must hedge their call option sale by buying the underlying stock; this is called a delta hedge.
If the delta remained unchanged during the term of an option, hedging would be a fairly straightforward activity. But the delta tends to change, and that’s where the gamma comes in, which measures the rate of change of the delta over time.
As the value of the underlying stock gets closer and closer to the call option strike price, dealers will have to buy more and more stocks to hedge, which will make it even more so. raise the share price. This is called gamma compression, and it’s what retail traders have exploited to their advantage.
“Anyone who runs out of the call option finds themselves increasingly exposed to the movement of the stock because the delta of the options has changed and the price of the stock has increased,” said Sosnick.
“So whoever is making these calls, which needs to be covered, is in the situation where they now have to buy more stocks. Taken to the extreme, it becomes a type of feedback loop similar to short squeeze.”
Two potential changes for the market
Short presses have been around for as long as investors have sold stocks. Even gamma pressures have been used by retail traders to drive stocks higher before. But the GameStop mania could have long-term implications for the markets.
“If a strategy works, people tend to keep using it until it stops working,” Sosnick said. “It has worked spectacularly, so in the short term the markets are adjusting.”
He thinks there will be two main adjustments. The first is that investors will be more reluctant to short sell and short sellers will be more reluctant to take extreme positions.
That prediction has already come true as Andrew Left of Citron Research announced on Friday that he would stop publishing research on short sellers after 20 years. Instead, he will look to “multi-bagger opportunities” for individual investors.
The second consequence is that investors are likely to see the prices of call options consistently higher compared to their equity counterparts.
Sosnick explains that while there has been a natural demand for put protection and a natural supply from above-market call writers, there is now a drastic shift in the amount of demand. for calls out of the course given the fervor of retail towards purchasing such. call options.
“What is the logical thing for the market to do in this situation? Systematically raise the price,” he said. “There is always a price at which someone is willing to sell, but if the supply-demand equation has changed, people will consistently ask for more money to sell options.”
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