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Gamestonk: The GameStop (GME) debacle has been presented as the result of irrational investor activity — a “frenzy,” a “speculative orgy” (in Charlie Munger’s words), a “game played by losers who don’t know what they’re doing” – a typical case of the Madness of Crowds.

This perspective is erroneous. The fact that the market is evidently not “rational” in the finance-theoretic sense deceives observers.

The underlying asset value is no longer reflected in share pricing. GameStop’s lousy, money-losing business isn’t worth 4000 percent more than it was last year at this time.

GME traders’ decisions are unreasonable

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In fact, the GME event is the consequence of a hyper-rational process. It is based on extremely precise calculations of specific outcomes with a significantly higher level of certainty than regular investment selections. There is no “crowd madness” here.

It’s a calculated, predatory attack against a surrounded and helpless opponent. Here’s how it went down.

The Typical Assumptions That Aren’t True

The naive view of the stock market is based on two self-evident assumptions.

1. Investors buy and sell stocks depending on the price – and whether or not they believe the price appropriately reflects the fundamental value of the company.

2. The market is “unrestricted.” Investing decisions are entirely at the discretion of the investor.

This is how we’ve been trained to think about the stock market since we were kids: as a huge convenience shop full of investment options, each with its own price tag. We are free to walk up and down the aisles, so to speak, looking at the merchandise and deciding which items appeal to us the most. We are free to make our own choices. We are not compelled to engage in any transaction.

There are several instances in which one or both of these assumptions are incorrect.

1. Transactions that are unaffected by price

Many stock transactions are made without regard for the share price, and as a result, are divorced from any consideration of the company’s underlying value.

The price/value correlations of the constituent components are not communicated by passive index-tracking investment funds. Michael Burry, the “Big Short” star investor, told Bloomberg News:

• “Private investing has taken price discovery out of the stock market.” Simple theses and models that lure investors into sectors, factors, indexes, or ETFs and mutual funds that imitate those strategies don’t necessitate the security-level examination that true price discovery necessitates.”

When we purchase a share of an index-tracking ETF such as the SPDR, we are purchasing all 500 companies that make up the index, regardless of whether they are overpriced or underpriced.

When we sell the SPDR share a month or a year later, we are basically selling all 500 companies at the same time.

In the meanwhile, some of those businesses have clearly outperformed others, and various components are now expensive or underpriced. These changes have no influence on whether or not to sell.

We’re selling them all at the same time, just because they’re in the index. If a business is added to the index, the ETF managers must purchase it at any price.

They’ll have to sell it if it’s dropped. Regardless of the cost. (In a previous column, I outlined this process in relation to Tesla’s rise since November of last year.)

Price-insensitive (and thus value-insensitive) purchasing and selling can be found in a variety of places, including

• Share buybacks by corporations, which are infamously indifferent to market value in many circumstances.

• High-frequency trading and market making — focusing on minor eddies in the order flow that provide opportunities to profit from the bid-ask spread.

• A variety of algorithmic and quantitative trading strategies that take advantage of minor, transient departures from established patterns that are unrelated to long-term firm fundamentals.

• Even basic momentum trading is insensitive to the price/value relationship – trend-followers buy a company’s stock because they feel the trend will continue, not because of their evaluation of the stock’s price relative to the company’s value.

According to JP Morgan, barely 10% of the market’s trading volume is based on old-fashioned research-based discretionary investment nowadays.

The remaining 90% of trades are completely or partially price-insensitive.

This dilutes the putative value-related information contained in the share price, paving the way for a second, more harsh sort of market dislocation.

3. Compelled Trades

The notion that all deals are entered into voluntarily – which appears to be accurate – is incorrect. There are numerous instances where one side of the deal is carried out under duress, involuntarily, and with little flexibility.

Traders on the opposing side of the transaction can take advantage of these situations by exploiting the fact that their counterparties have little or no room to manoeuvre.

One example is a margin call. If the share price falls too far below the collateral value, investors who borrowed money to buy shares are compelled to sell — at the worst possible time and at a loss.

Forced sale is a common occurrence. Is there such a thing as compelled purchasing, though?

Yes. There are a number of circumstances in which a market player has no choice but to buy shares, and typically at a very low price.

Another of the ancient techniques of the marketplace is cornering these compelled buyers and feasting on their misery. This is critical to comprehending the GME occurrence.

A Hi-Tech Corner for the Twenty-First Century

In the past, great “corners” – in gold, silver, copper, onions, and chocolate – almost always failed.

In the case of GME, the predators (Reddit) figured out how to create a unique and highly effective corner.

They did it by merging two different procedures for the first time, probably for the first time ever.

• a Short Squeeze, which is ancient, well-understood, and difficult to master.

• a recent breakthrough known as the Gamma Squeeze, which gave the Reddit swarm the leverage they needed to power the corner and turn it in their favour.

The Squeezed Squeeze

Short sellers borrow shares and sell them for a profit. They’re hoping for a price drop so they can repurchase those shares for less than they paid for them in the short sale.

If the stock price rises, the short seller’s position loses value since the shares must be bought back at a higher price, resulting in a loss.

There will be a margin call for further collateral to be posted. If the stock price rises too high, the short seller will be forced to purchase back the stock at a loss (“cover the short”).

This forced buying raises the price even further, putting pressure on additional short sellers who are still holding out.

When they cover at a higher loss, their buying drives the price up even more. The price could skyrocket as a result of the squeeze.

The “Longs,” new buyers, are drawn to this scenario. They buy shares with the intention of selling them to the frantic shorts at the peak of the squeeze.

It’s a slugfest with the customary short squeeze. The Shorts, on the other hand, have a built-in advantage. They gain money as they defend their position by selling more. As the war progresses, the Longs will have to rely on cash.

The Volkswagen Porsche Case

An attempt by Porsche to take over Volkswagen was one of the biggest short squeezes in modern history.

Despite the fact that VW is nearly ten times larger than Porsche in terms of sales, the smaller firm was able to manufacture the squeeze and gain a majority voting interest in VW stock. Short sellers were slaughtered.

Intraday trading was even more dramatic during the peak of the squeeze, from October 27 to 29, with fluctuations of roughly 100 percent in a matter of minutes.

The situation is unique due to the enormous size of the target. VW momentarily became the world’s most valuable corporation when the pressure played out.

The Porsche strategists added a twist by surreptitiously purchasing options on top of the shares they already owned.

• “When Porsche revealed that it held 42.6 percent of the stock and had options on another 31.5 percent, the shorts hurried to cover, and the price skyrocketed…”

• “On paper, Porsche earned between €6 and €12 billion. To put such figures into context, Porsche’s total revenue in 2006 was little over €7 billion.”

The CEO of Porsche has been accused with market manipulation (later acquitted). The leading short-seller took his own life.

It took a lot of effort to plan this event. A conventional short squeeze necessitates a significant amount of ammunition ($$) on the buy side in order to corner short-sellers and force them to cover. It’s difficult to match the shorts dollar for dollar.

Porsche’s shift took three years and a lot of planning. It’s for this reason that successful squeezes are so uncommon. Until now, that is.

The Gamma Squeeze from GME

The game-changing move is known as a Gamma Squeeze, which is a bit of a mouthful.

It’s a very new invention; if you Google the phrase, you’ll get only a few stories from January or February 2021. It’s both creative and effective.

It also uses options, but in a different way, to increase the pressure on short-sellers.

Here’s a simple illustration. Purchasing a Tesla call option is the first step. (As of February 26, 2021, the figures are accurate.)

• Tesla finished at roughly $675 a share on February 26; two days ago, it had closed at $742; two weeks previously, it had closed at $816 – so you believe it might go up again?

• For $725, you purchase an option to purchase a share of Tesla. The option is set to expire in two weeks, on March 12th.

• The option is priced at $15.

• You profit if Tesla’s price rises above $740 ($725 plus $15) on or before March 12.

• You lose $15 if the option expires on March 12 and the stock is still below $740.

Tesla’s stock price

The option is worth $76 if Tesla’s stock price returns to $816. Your $15 investment has returned more than 500%. (By contrast, if you acquired a Tesla stock for $675 and sold it at $816, your profit would be only 21%.)

Your opponent is probably certainly a market expert with knowledge of pricing and selling strategies. His risk structure is the polar opposite of yours.

His potential is restricted to the premium ($15 in this case). His disadvantages are limitless.

He is obligated to deliver at the strike price if he writes a naked call option and the price rises.

He’ll have to buy on the open market, which would cost him $816, a net loss of $76.

Consider how this affects the psychology of both the buyer and seller of the option.

This might be viewed as a simple wager by the Buyer. He could lose (at most) $15, but he could also win a lot more.

The Seller can only make $15, and if the stock rises, he will lose a lot of money. He has effectively taken on the same risk as a short seller.

This is hardly a risk that a professional would take, given Tesla’s recent history (over $800 just a few days ago). He’ll have to find a way to get around it.

Risk can be mitigated in a variety of methods, the most of which are too technical to detail here.

When the seller writes the option, the easiest alternative is for him to acquire a share of Tesla at $675. This is an unrestricted call.

His chances of a significant price increase are now nil. (A negative move is now a possibility, but we can disregard it for now.)

This isn’t precisely a forced trade; the seller could take a chance and go naked. He could also transfer the risk by purchasing or selling other types of options. Writing a call option, on the other hand, almost always causes someone, somewhere, to buy a share of the underlying stock as a hedge.

The Gamma Squeeze relies on the fact that call options are a far less expensive way of applying pressure to the shorts. In this case, the choice is only 2% of the cost of purchasing a whole Tesla share.

This changes the game tremendously in favour of the squeeze masterminds.

They can force the shorts to take on $1.00 of new risk with just two at-risk investments.

This is now a different battle, even with the shorts’ liquidity edge. It allows the “retail” hordes that gathered around GME on Reddit to play the game.

They went after GameStop’s massive uncovered short positions (which accounted for well over 100% of the company’s outstanding float).

Whereas it used to take a lot of money to even attempt a corner or a short squeeze, now any number of tiny traders can play. The tipping point is rapidly passed. The shorts had no choice but to cover.

Because the degree of confidence is so high, the technique is hyper-rational.

Betting on share price changes based on the normal ebb and flow of market information is far riskier than betting that purchasers who are obliged to buy would really buy.

And if the gamma squeezing trader can position himself in such a way that the forced buyers have no choice but to buy from him, that’s money in the bank.

The first significant example of this unique strategy is GameStop. This phenomena is still little understood by the market (which is why so many professionals were savaged). Quantitatively, it’s unclear how much leverage the Gamma Squeeze adds.

Alternatively, how repeatable it is. Or how stable is it — could a counter-surge of put options destabilise it just as easily?

(Which would take advantage of the covered call’s new downside risk.)

To be honest, I’m not sure. However, it appears that attempts to implement this strategy are increasing.

In the previous two years, the daily volume of options trading in the United States has doubled. Retail dealers have seen the greatest increase.

The structural detachment of investment decisions from traditional price and value conceptions, which can lead to scenarios of coercive asymmetry in particular trading relationships, is exemplified by this new squeeze approach. When purchasing or selling is pushed, it might change investor psyche and cause major market dislocations.

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Dimple Gola is the Chief editor at Bollywood and the Co-Founder of ‘Chop News'. She writes about Entertainment, Youth related topics, especially on Movie Reviews and Box Office Collections.

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