AOTW: GameStop and Reddit: What Gives?

 
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AOTW: GameStop and Reddit: What Gives?
AOTW: GameStop and Reddit: What Gives?                                                   January 29, 2021
Good morning loyal AOTW fans,

Interesting week indeed in marketland, not so much for a pickup in volatility and a mild roller
coaster of a week that resulted in most major indices shedding some recent gains, down 2-3% on the
week.

What dominated the headlines and Contego inboxes, texts from friends and family, was the question
“What’s up with this GameStop stock and what is a Reddit?”

I’m paraphrasing, but it was essentially that, the question of the week. I will break this down into
some key explanations, then gradually tie it all back together in a bow, doing my best to avoid excess
Wall Street jargon. Try to see it through, it’s on the long side, but a story for the Ages.

First: Reddit.
Reddit is in layman’s terms an online chat board. Users can create “subreddits,” or forums of
conversation about specific topics. The subreddit in this story is called “r/wallstreetbets,” better
known as “WSB” or Wall Street Bets, is a forum that has existed for years for its members to discuss
stock ideas. Before WSB was taken private due to overwhelming use this week, it had 4.3 million
members. Put a pin in that last point.

Second: GameStop (ticker symbol GME on the New York Stock Exchange)
GameStop is the store you used to take your teenagers to, maybe you lined up at 5am in an extreme
case a few years ago, awaiting the new release of the Call of Duty game on Xbox or PS3/4.
GameStop is a physical retail store, and in recent years, the majority of gamers simply buy and
download their games online through their console, forgoing the need for a physical disk to run the
game. As a result, GameStop is a money losing business that many financial analysts believe may
ultimately go out of business.

Third: The Hedge Funds, GameStop and Short Selling
Based on the view that GameStop was/is a primary candidate to become insolvent, some Wall Street
hedge funds were attempting to make money betting against GME, by selling it short. So, what is
short selling? You’re used to the old expression “buy low, sell high” when it comes to making
money in stocks. Short selling is simply the opposite. You would short a stock (sell high) if you think
it’s overvalued, and if you’re right, buy it back at a lower price (buy low) and pocket your profit. Key
point here: a short seller doesn’t own the stock, so they have to borrow the shares from someone
who does (usually a big broker dealer or financial behemoths like Blackrock and Fidelity make
money loaning stocks to hedge funds and charging a daily fee). When you borrow a stock, much like
borrowing to buy a house, you have to put up collateral, or margin in finance speak. That collateral
can be cash or other stocks in your portfolio. Another key point to remember is this one.
Collateral/margin.

Fourth: Reddit, Melvin Capital and the “Short Squeeze”

     Contego Wealth Management | Raymond James Ltd.           750-45 O’Connor Street | Ottawa, ON | K1P 1A4
                         613.369.4600 | Toll Free: 1.866.552.0889 | Fax: 613.369.4699
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How does hits all start to tie together around this GameStop story? GME shares were trading last
summer as low as $4, and had surged nicely following the Pfizer vaccine news in November like
many retail stocks, to $20 by early January (GME was at $332 as of Friday 11am). This is where
Reddit comes in. And who is Melvin Capital? Melvin Capital is (teaser: was) a $13 billion hedge fund
that had a big short position in GME shares. The WSB crew decided in mid-January that they
wanted to turn the tables on Wall Street and go after Melvin Capital and other short sellers of GME.
So their million members (and growing) rallied together to start buying GME shares en masse, as
well as GME call options. (What the heck are GME call options? That comes next) Essentially, the
WSB crew wanted to band together and create enough upward momentum to put Melvin in a “short
squeeze” position. What is a short squeeze you ask? Recall the point that short is in essence
borrowing, and collateral is posted. When the value of the borrowed asset goes up, the amount of
collateral required goes up with it. Think of a house that’s leveraged way up, and as the value drops,
the equity in the house drops below a minimum level, and the borrower has to either sell or put up
more collateral. A rising stock crushes a short seller’s equity, and they have to post more collateral.
When the value of the shorted stock goes up FAST, the short seller can be forced to sell due to lack
of collateral, called a “short squeeze.” This is what WSB did to Melvin, on Wednesday of this week
they drove GME’s value up $14 billion in a single day. Melvin Capital’s fund was worth $13 billion,
so you can imagine their big short in GME “felt bad,” as the kids say.

The final piece of the puzzle: Leverage and Call Options
A common theme as we’ve seen stocks like Tesla soar to massive heights (up 800% in under a year
and 300% since September), where the value of the shares really cannot be explained vs what the
business generates in revenue or profit. You’ve probably heard the term “Robinhood,” and not the
old story/movie, but the day trading app. Robinhood takes low cost investing to a new level of
cheap, charging sometimes a penny or less per share or option purchased. There’s that option term
again. We’re getting there. In other words, Robinhood users can play with very small amounts of
money and not be crushed by fees. Robinhood users have been big fans of Tesla as one and have
been given credit for helping drive up its value. Many Robinhood users are younger (most in fact),
and it is well-established that many are trading with US government stimulus checks. How can
THAT little money (a couple thousand dollar per user invested) affect a stock that is now worth
$800 billion? The answer: leverage. Leverage using call options, and a lot of them. Options are used
by hedge funds and more sophisticated investors, usually to hedge their market risk, but can also be
used to speculate. Go back to GameStop, call options and the stampede are best explained by an
example. Jan 11th. GME trades at ~$20. The Reddit/Robinhood crowd began buying call options on
GME. Hypothetical pricing as I don’t know exactly what the numbers were, but this explains it:

   1. Instead of buying $20 GME shares, one can invest in the RIGHT (not the obligation) to buy
      100 GME shares at $25 for anywhere from 1 weeks to 2 years, using call options. Let’s use a
      March $25 call on GME.
   2. The RIGHT to buy 100 GME up to mid-March at $25, sells for $1 per contract, so $100
      gives the right to buy 100 shares, $1,000 for the right to buy 1,000 shares.
   3. If GME never goes above $25 by mid-March, Robinhood investor loses his $1,000 if he/she
      bought 10 contracts.
   4. In this case though, as both options and shares of GME are bought up by the WSB crew,
      the share price takes off (because there are by this point 2 million members and counting).
     Contego Wealth Management | Raymond James Ltd.           750-45 O’Connor Street | Ottawa, ON | K1P 1A4
                         613.369.4600 | Toll Free: 1.866.552.0889 | Fax: 613.369.4699
                                       www.raymondjames.ca/contego
5. When GME hits $25, the options “market maker,” usually a big bank (Goldman Sachs, JP
       Morgan, etc.) who sets the price of those options contracts, has to buy 1,000 shares of
       Gamestop to cover their position so they don’t lose money doing their job. GME market
       maker buys 1,000 shares at $25, has sold those already to Reddit user XYZ at $25 with the
       option contract, so he keeps his $1 premium and is happy.
    6. As more and more users buy shares and options, GME keeps rising, the market maker keeps
       buying shares, and the snowball continues.
    7. You can see then, if 2 million Reddit/Robinhooders piled on and put even $1,000 each into
       GME $25 call options, they are ultimately forcing the market maker to buy $5 billion worth
       of stock when GME trades through $25. (2M people x 1,000 shares each x $25 per share =
       $5 billion)
    8. Here’s the problem with 200,000,000 shares of GME being forced to be purchased. GME
       only has 70 million shares outstanding. The same shares are being bought, sold bought and
       sold again, mutliole times in a single day the share ownership changes completely, and a
       desperate short seller like Melvin Capital has to pay whatever the market commands to get
       out.
    9. In case you haven’t looked it up yet, GME was trading midday Friday at $332 a share, having
       hit a high of $483 on Thursday.

This Robinhood options craze was borne out of bored Robinhooders at home with some spare cash
it seems. Look at the chart below, courtesy of our friends at Picton Mahoney. “Small lots” of
options (10 contracts or less like the example above) usually add up to $1-2 billion a week in
premiums (the $1,000 in the example above) paid. Now? $10-12 billion. Remember you have to
magnify that last figure by 100 to get to the actual final value of the shares traded when the options
purchased are profitable. Now you can understand the influence of what is really a populist
movement.

Is All of This Legal?
Robindhood is apparently musing about banning purchases in stocks like these, a move sure to
infuriate its users. There are rules around large institutions manipulating markets by using their
buying power to move stocks and markets with hundreds of billions of dollars in buying power. No
such rule exists though, for small “retail” investors. Will that change? Maybe, but this is quite a story
indeed.

Clearly some WSB posters and other jumped in and won big here, as long as they remember to
sell…the losers will be those who get in late and hang on as the GME shares inevitably tumble back
to the stark reality that it is a struggling business and not one worth $23 billion as the stock market
says it is currently. The biggest loser? Melvin Capital. Melvin’s $13 billion fund is being dissolved as
we speak. How much did they lose? Not yet a known number, but to collapse a $13 billion fund and
force it out of business, I would dare prophesize that most of the money is gone. Quite a story
INDEED.

No link, this is a Contego original, penned by Trevor Johnson. I’m glad you “Reddit.”

Have a great weekend.
     Contego Wealth Management | Raymond James Ltd.            750-45 O’Connor Street | Ottawa, ON | K1P 1A4
                          613.369.4600 | Toll Free: 1.866.552.0889 | Fax: 613.369.4699
                                        www.raymondjames.ca/contego
P.S. We have looked at the thought of profiting as the GME story fades away and the shares
inevitably tumble…your only realistic option is to short the shares, and those shares will be hard to
find & borrow. Put options on GME are priced to a point you simply cannot and will not profit
from them. Shorting is not for the faint of heart, just ask Melvin Capital. The expression goes
“markets (in this case Redditers) can stay irrational longer than you can stay solvent” in short selling.

Trevor M. Johnson, CIM, FMA
Raymond James | Financial Advisor |
Contego Wealth Management
750-45 O’Connor Street | Ottawa, ON | K1P 1A4
 613.369.4660 | Toll Free: 1.866.552.0889 | Fax: 613.369.4699
www.raymondjames.ca/contegowealthmanagement/

Personal Assistant:
Karol Phillips | Financial Advisor Associate |
     613.369.4662
karol.phillips@raymondjames.ca

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      Contego Wealth Management | Raymond James Ltd.               750-45 O’Connor Street | Ottawa, ON | K1P 1A4
                              613.369.4600 | Toll Free: 1.866.552.0889 | Fax: 613.369.4699
                                              www.raymondjames.ca/contego
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       Contego Wealth Management | Raymond James Ltd.                         750-45 O’Connor Street | Ottawa, ON | K1P 1A4
                                  613.369.4600 | Toll Free: 1.866.552.0889 | Fax: 613.369.4699
                                                   www.raymondjames.ca/contego
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