Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (2024)

Everyone that follows the market, and many that do not, have watched the meteoric rise in the price of GameStop (NYSE:GME) in awe over the past few weeks.

Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (1)

Quickly recapping, GME stock traded under $20/share as recently as January 12th, then

  • Doubled to $40 by January 20th
  • Doubled again to $80 by January 25th
  • Nearly doubled to $148 by January 26th
  • More than doubled to $347 January 27th
  • Lost 2/3rds of its value to an intraday low of $112 on January 28th
  • Nearly tripled from the intraday low and closed January 29th at $325

This is an incredible event, and looks to be a combination short squeeze and gamma squeeze which are both feeding on each other, all fueled by a speculative frenzy loosely coordinated by millions of small investors discussing via the Reddit channel WallStBets.

What are the mechanics behind the GameStop squeeze?

The mechanics behind what is happening with GameStop are incredible and look to be a combination short squeeze and gamma squeeze.

Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (2)Data by YCharts

What is a short squeeze?

Most investors have heard of short squeezes. They have happened for a long time and are well understood.

When owning, or being long, a stock, your maximum loss is the amount of your investment. As long as you're not using margin, you can own a stock for forever and can't be forced to sell. If you believe a stock is undervalued, you having the luxury of time for the market to appreciate it and the stock to hopefully rise.

When shorting a stock, the basic premise is simple enough. If you believe the shares of a company will fall, you "borrow" shares via your broker, sell them immediately, and then hope to "return" them by buying them back at a lower price, keeping the difference. But unlike owning a stock, your gain is capped, while your maximum loss is unlimited.

As an example, say you shorted 1000 shares of GameStop at $20 on January 12th hoping it would drop to $17 where it started the year. If this played out as hoped and you covered at $17, you would make a $3000 profit. But GME skyrocketed instead of dropping, and assuming you had the cash to stay in the trade, you would have a $300,000 loss from shorting $20,000 in stock!

Most investors would not be able to tolerate this kind of loss, and at some point would be forced to cover. When a highly shorted stock starts to rise, it can quickly turn into a buying frenzy as shorts try to cut their losses and exit the trade. This can result in some dramatic increases in price in a short amount of time.

What is a gamma squeeze?

Gamma squeezes are a more recent phenomenon, fueled by the popularity of options, especially with the relative ease at which newer investors have access to them through brokers like Robinhood. The mechanics are different, but themes are similar: forced buying and a feedback loop.

When investors purchase call options looking for leveraged gains, there is a counterparty - someone on the other side of the trade. In some cases, that counterparty is long GME stock and is selling a covered call, trading away upside in exchange for additional income/premium. But with options, usually you are not trading with another individual investor and instead are trading with a market maker.

Options market makers are a bit like bookies; the ultimately want to be neutral on a stock and just make money creating a market. They are not looking to speculate and will hedge away as much risk as possible. How they do this is complex, but the most basic tool to hedge exposure from an uncovered call option is to simply purchase the underlying shares.

This can help fuel the same speculative frenzy as a short squeeze, where the rising price creates a feedback loop that encourages more call buying and performance chasing.

Why is GameStop so heavily shorted? How can it be over 100%?

GameStop is a great example of why shorting any stock is dangerous, because it seems like the great short. GameStop's core business of selling physical video games to consumers via retail stores is being disrupted by digital downloads, similar to what happened to Blockbuster. Before COVID, it had already shrunk from 7,276 stores in February 2018 to 5,509 stores in February 2020. But this year, the shares rose from $5 in August to $20 by Christmas as lockdowns fueled interest in gaming. Shorts believed this boost was temporary and GameStop would resume its path to bankruptcy as soon as the COVID related demand went away.

Shorts were so certain of this outcome that they drove short interest as a percentage of float to over 100%.

Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (4)

At first glance this seems impossible; if every share in the float is lent out and then shorted, that should equal 100%. But short interest can exceed 100%, even without naked short selling, which is a practice where shares are shorted without being able to locate shares to "borrow" (this is effectively prohibited by the SEC.)

As an example for how this can happen, assume Investor A owns 100 shares of GME. Investor B shorts GME and sells these shares, which are purchased by Investor C. Investor D shorts these shares, which are then purchased by Investor E.

Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (5)

In this example, the "float" is 100 shares, but 200 shares are sold short, so "Short Interest" / "Float" would be 200%.

Why short interest above 100% is rare in practice

In practice, this is rare, for several reasons.

  1. The greater the short interest in a stock, the higher the risk of a short squeeze. Many investors will avoid "crowded shorts" for this reason.
  2. Most brokers charge interest on borrowed stocks. It's an opaque system, where the interest rate varies widely and the rate often change daily. But in general, the interest rate is higher when the demand to borrow shares is greater. So the carrying cost of holding a short position in a heavily shorted name can make it less appealing to short sellers.Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (6)
  3. Above is an example of GME, where there a no shares available to short, MAC, where there are shares available to short, but at a 13.5% interest cost, and TWTR, where there is very little short interest and no carrying cost to short.
  4. Irrespective of the interest rate, a broker needs to be able to locate shares before a customer is allowed to short. Brokers also have broad discretion on deciding what is allowed to be shorted, and may determine that particular shares are too risky and not allow shorting at all, or require extreme amounts of collateral before accepting the trade.

This has happened before: Volkswagen Edition

While this is generating a lot of press coverage, I ultimately don't believe much will come from this, and the SEC will feign interest but take no action. While this situation is unique because of the size of the reddit WallStBets community, smaller investors discussing and coordinating activity online has happened since the 1990's.

Even after the dramatic price increase, GameStop remains relatively small at a $22 billion valuation compared to today's market leaders. To put that in perspective, Tesla's (TSLA) 5% decline on Friday January 29th wiped out $40 billion in market value. But not long ago, a similar short and gamma squeeze briefly vaulted Volkswagen (OTCPK:VLKAF) (OTCPK:VWAGY) to the most valuable company in the world, eclipsing the market cap of then-leader Exxon Mobil (XOM).

This happened in October 2008, in the middle of financial crisis, an otherwise lucrative time to be a short seller. Many automakers were viewed as bankruptcy risks, and in fact, Chrysler filed bankruptcy in April 2009 and General Motors (GM) followed a month later.

Dubbed the Infinity Squeeze, it started with short interest in Volkswagen that was higher than normal, but not extreme, around 15%. At the time, Porsche was an independent entity and owned a ~30% stake in Volkswagen (today, Volkswagen owns Porsche.) Porsche, who was heavily indebted and also in trouble, knew Volkswagen's available float was lower than most realized since local German government funds and index funds owned the majority of shares.

Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (7)Data by YCharts

So what did Porsche do? It starting buying call options - lots of them. It bought enough to give it an effective 74.1% stake in Volkswagen, just 0.9% below the level where financials would be consolidated. Then, on a Sunday with the market closed, it announced this to the world and stated its intention to "raise this target to 75% in 2009 as long as economic conditions permit."

This set off an incredible squeeze in which Porsche made ~$10 billion and hedge funds lost $30 billion. Hedge funds cried foul and Porsche's former CEO Wendelin Wiedeking and ex-CFO Holger Härter were charged with market manipulation, but were ultimately acquitted. Porsche beat hedge funds at their own game and likely prevented their own bankruptcy in the process.

Conclusion: How does this end? Implications for Robinhood?

This will end like every other speculative mania, where those that get in late lose most of their money. If and how much higher GME, AMC Entertainment (AMC) and others go from here, and when they correct is anyone's guess. But I'm fairly confident that a year from now, GME will be lower than it is today.

Ultimately, the only real fallout I see from this is investors leaving the Robinhood platform, especially since the major brokers all offer free trading now. While Robinhood may be immune to legal liability from their user agreements, I believe they crossed a line when they restricted buying shares in individual securities for customers that had sufficient cash in their accounts.

I do not believe their actions have anything to do with protecting their clients; they were protecting themselves. It's likely that they ran into liquidity issues of their own. First Robinhood's CEO claimed that there were no liquidity issues, but then immediately drew over $1.5 billion in credit lines and emergency funding.

It is one thing to restrict margin borrowing on individual risky securities or to not offer options trading on them; it is another issue to restrict purchasing individual securities when a client has sufficient cash. As of Friday, Robinhood was restricting 50 different stocks, including limiting stocks like GM to 1 share. GM has almost no short interest and has traded in a 10% range over the past two weeks. On Sunday, Robinhood significantly relaxed restrictions and only 8 stocks are now restricted. This moving target of what is allowed should erode investors trust in the Robinhood platform. If I had a Robinhood account, I would close it and would recommend other investors do the same.

Fishtown Capital

Individual investor and family office principal with over 20 years of investment experience. I favor fundamental analysis and look for individual issues and asset classes that are out of favor and represent a good risk/reward trade off. I often employ options strategies, covered calls on companies I own that have gotten ahead of themselves, and writing puts on stocks that I'd like to own at lower prices.Educational background Finance MBA (NYU Stern) with Computer Science undergraduate.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Why Did GameStop's Stock Price Go Up: Explaining The Squeeze (NYSE:GME) (2024)
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