This week we had a wonderful technical discussion on recent event of short selling involving Gamestop. We discussed the role of Robinhood and the learnings for investors out of these extraordinary chain of events. We went into technical details of what a short squeeze is, what happened with GME, why Robinhood did what they did, what happened at WSB and if there are takeaways from this saga. Look out for an in-depth discussion on why Robinhood could have gotten such a large demand for capital.
This is a transcript of an internal discussion of the Finvisage team about the short squeeze activity on WallStreet in Jan2021.
AJ: Its great to be with everyone. We’ve all been interested in the stock markets recently and have had animated discussions in our slack. Thanks Trips for making this roundtable discussion about this topic. I think it interests everyone here. Ok who wants to kick it off.
JR: Let me start by the most basic question, a term that has always had a negative vibe to it, “Short selling”. What is it and how does one choose which stock to short sell?
AJ: If an investor thinks the price of stock will fall, he/she can borrow the stock with a promise to return the stock at a fixed time in the future. The investor will sell the stock in the market and buy it back before expiry of his short. He/she is hoping the price of the stock will fall in that period thus netting him gains. It is a risky strategy. The lowest the price can go is zero. But there is no ceiling to how high it can go. And we have seen live the best example of this over the last few days. Thats why I say this is also very educational. The fair value chatter that people seem to rely on holds less and less value in my opinion.
It isn’t illegal in the US. You have to understand what happens when an investor shorts the stock. The title to the stock changes hands to the borrower for that period of time so technically there is an actual underlying that is being sold. However,we all know how creative finance can be. Derivative contracts make it possible to multiply the impact of the short making it possible to profit from a short position larger than the actual shares borrowed.
There are also costs related to shorting. Short sales can only be made via margin accounts and margin interest can be a significant expense. The interest payable on short trades can add up over time, especially if short positions are kept open over an extended period. Shares that are difficult to borrow have something called “hard-to-borrow” fees that can be quite substantial.The short seller also is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.
LS: If the short seller’s belief is that the stock shall fall, then why Gamestop? During the pandemic and lockdowns, with people stuck at home and schools closed, wasn’t a gaming company due to make profit?
AJ: Gamestop is a ‘physical’ retailer in America. It sells games, consoles and other electronics in American malls. To be honest it’s not anything new and exciting, and in fact it wasn’t doing very well because of the pandemic. Why GME caught the fancy of short sellers really depends on their individual analysis. However due to the physical nature of its business and absence of online presence would have made people conclude that it would be severely impacted during the pandemic and have to shut down eventually.
LS: So was there no fundamental basis for the Gamestop’s stock to rise?
AJ: While the meteoric rise into the hundreds of dollars of the share price is definitely a momentum play and, in my opinion, unmoored from reality, before this there was a case for the stock to do well. Gamestop is the only major physical store dedicated to gaming in the US. It has a healthy market share. In a survey in the US, it was indicated that upto 25% of people buy their new games at gamestop and 40% buy their second-hand games there. It had already put in place a reboot plan. It was going to leverage on its legacy business and cut costs there. Secondly it was planning to invest in reinventing itself as a premier gaming hub within the thriving gaming industry which is valued at $150 bn. This was a high potential move and their test stores in Oklahoma had done well.
If you have seen the movie ‘The Big Short’, you will know about Michael Burry. Avinash you mentioned it on our channel. He made millions shorting the housing market in 2008. His fund is now called Scion. Scion had invested in GME in 2019 and had done well out of it – his investment had doubled in a year. That was before this recent rally. If he still had GME in his portfolio he has made stupendous gains. So in short it is not true that there was absolutely no fundamental basis for an investment in Gamestock.
LS:Okay, how did this interest in GME stock start?
AJ: On the 12th of January the stock was at $19. On the 13th of January it jumped to $31. It rallied further over the next 4 trading days and on Jan 21st it was at $43. On 22nd it jumped to $65. The next trading day it was at $76. Then on the 26th of January there was a burst upwards to $148. It didn’t stop there and over the next trading days it reached $400 before pulling back to $320 and now to $100. The intra-day volatility has been phenomenal. All of you are aware of implied volatility -we use it in ‘Finvisage’ derivative pricers all day. Well,you are used to seeing implied vol number ranging between 5% and 40% from FX to oil. But if you wanted to buy a call or put option on GME stock youwere paying an implied vol of 300%. Let that sink in for a bit. 300% was the implied volatility of these single stock options. These were clear indications of a ‘short squeeze’ on the stock.
JR: AJ, what is a short squeeze.
AJ: First let me step back and explain who started this. /r/wallstreetbets is a subreddit – basically a forum on reddit where retail investors get together and discuss stock ideas. It has been around since 2012. Its moderators describe it as if 4chan found a Bloomberg terminal. The point tonote here is that this aggressive nature of the WSB community is not new. They are known for aggressive trading strategies, which primarily revolve around highly speculative, leveraged options trading. That is why options were so important in the GME saga as well. Members openly ignore fundamental investment practices and risk management techniques;some people will call the activity gambling. Personally,I think it has been the most entertaining things on the internet for the last 10 days and to be honestvery educational too. Once redditters on the forum wallstreetbets realised that hedge funds were short, they bought up the stock in bucketloads which caused the price to rally. We know what must have happened then. The rally would have triggered margin callson short sellers. Either they had to cough up money to cover their margins, or buy back the stock, crystallise their losses and cover their positions. When they went to cover their positions, i.e.buy back their stock, that rallied the price further thus triggering further stop losses. This spiral led finally to the stock rallying to meteoric levels. This is a short squeeze.
I call it trying to catch a train that is leaving the station -the sooner you realise there is no chance in hell that the train is going to stop the better it is for you. If you’re stuck on the train and want off, you will get off sooner. If you’re stuck on the platform and want on you will jump on. In both cases the later you leave it to do, the more hurtful it will be.
JR: Why did the redditters pick GME as the stock squeeze then?
AJ: It was posted on reddit that 140% of the GME stock was shorted. How is it possible? Hedge funds put on leveraged positions using derivatives which mean that the effective short on the stock can be more than the available float. Investors knew at some point in future the hedge funds will have to buy shares from the market to close their positions.Post 21st Jan there was an exponential increase in the number of posts on GME. Citron research, which is a prominent short seller, had just brought out a report saying the price was overvalued and ripe for shorting. But members of the Reddit board, who had been generating interest in the stock, criticized Citron on the Reddit message board and continued praising the stock. It soon became a momentum trade and a way for people to express their angst against a set of people that were perceived to have done well out of the 2008 financial crisis when these retail investors suffered. Whatever may be the perception, only after understanding the data can we conclude whether that is true or not.
Trips: But why now, almost a year after the pandemic started. Why has the retail investor suddenly become important enough to be moving the market against the expectations of hedgefunds who are traditional movers of the market.
AJ: Time and Money.
Time because during the lockdown in the US, many young people were forced to stay at home. They lost their day jobs and turned to trading for various reasons -tackle boredom, make some extra money,interest in the markets, mental stimulation or something else. Money: It is alleged that the stimulus checks that every American received contributed to the meteoric rise of the share market. Whileit can’t be definitively proven either way, some money inevitably found its way into stocks popular on reddit too.
Avinash: How has options trading played a role in this?
AJ: Trading apps like Robinhood allow retail investors to trade on single stock options. So people were buying call options on GME stock in place of the underlying stock. Not only retail but large investors like Chamath Palahapatiya also joined in the call buying frenzy. He tweeted about this and also did a very insightful interview on CNBC. These options were held till expiry and then exercised to take delivery of shares because they were so massively in the money. Now think about the option writer here. He/she had to go into the market, buy the shares and transfer them to the call option buyer on exercise date. That pushed the price of the share even higher.
LS:A name popped in the middle ofthis. Robinhood. What is it?
AJ: Robinhood is a trading app in the US that claims to democratise finance. It made available stocks and options to trade for zero commission to its users. This growing popularity of no-commission brokers and mobile online trading potentially contributed to the growth of trading trends like WSB. Now Robinhood was in the news because they made lots of people angry. To understand what Robinhood did and why, it’s important to look slightly under the surface. There is an introducing broker dealer called Robinhood financial. That is the app that their customers use to trade and Robinhood financial processes these trades. Then there is a clearing broker dealer called Robinhood securities that clears and settles the trades. Robinhood obviously saw a lot of activity on 27th Jan. The margin file that they received from National Securities clearing corporation asked them to place a deposit of $3bn. This was an unusually high request for capital for a firm that at that point had raised a total of $2bn in venture capital. What goes into calculating this deposit number? VaR is a critical input. All of you are well aware of how to calculate value at risk as we do it in ‘Finvisage’. You all know there are 3 methods to calculate VaR. The NSCC uses the parametric method. To estimate volatility, which is the most important input in the formula, the NSCC can use any generally accepted portfolio volatility model. They take into account historical data as well such as:
a) an exponentially weighted moving average volatility estimation using a decay factor of less than 1, or
b) an evenly weighted volatility estimation using a look-back period of not less than 253 days.
Now that we know that the increased volatility in GME stock was going on since at least the 13th, this would have definitely contributed to a higher volatility estimation. Since volatility has a large influence on the calculation of VaR, it’s not difficult to see why they saw such a large demand for capital. The NSCC enhances the VaR charge by including an additional bid-ask spread risk charge which acts as a multiplier. The bid-ask spread on stocks that were experiencing high volatility that day was a few dollars.
In addition, the NSCC includes a Margin Liquidity Adjustment charge or the MLA. The MLA chargeis calculated to address the risk presented to NSCC when a Member’s (here Robinhood) portfolio contains large Net Unsettled Positions in a particular group of securities with a similar risk profile or in a particular asset type. Now put these all together andthe picture becomes clearer why Robinhood experienced such a high request for capital that day. Do I think it should have come as a surprise? No. For a company doing what they do, this is their bread and butter. Scenario planning should have been carried out -someone definitely dropped the ball which then led to the subsequent controversies. So let’s understand what they did after they received the demand for $3bn. They picked up the phone and called up the NSCC to see if the demand could be negotiated down. The NSCC is not a government institution. The Indian equivalent whose initials are also NSCC is a wholly owned subsidiary of the NSE. The NSCC in the US is a subsidiary of the Depository Trust & Clearing Corporation the DTCC which is owned by a consortium of banks and brokers. The NSCC is regulated by the SEC. They decreased the demand on Robinhood to $1.4 bn. Eventually more discussions led to the deposit being reduced to $700mn. Robinhood raised $1bn within 24hrs and paid this amount. But now they had to come up with a strategy to manage the risk for the next trading day. Because the volatility was not abating and if they did nothing, there would be another massive demand eventually. I would say they were a bit late in realising this, and if whoever was supposed to had done their job, they would have been better prepared for this. Anyway. They decided to allow only position closing trades on stocks like Gamestop and AMC. This would forcibly reduce their exposure resulting in a reduction of request forcapital. Now this is interesting and it’s important to understand why they did this. They knew this would almost exclusively hurt their users.
Some of you trade equities in your free time. You will know more than anything how much of a nightmare it can be to be restricted in your ability to trade your open positions at will. If Robinhood stands for democratisation of finance,then why do the one thing that will hurt your customer base the most.
Avinash: So if it’s not the users of their app, then who is really Robinhood’s customers?
AJ: The customers of Robinhood are the hedge funds to whom it sells the customer flow. It makes money by selling users’ trades to other large firms before they’re actually executed. Those firms make money by effectively seeing what the retail investors on Robinhood are going to do before they actually do itand acting accordingly. Those firms are basically buying information that then informs their own trades. It turns it’s users, more accurately their trading information, into a product and asks for payment from funds for information of this order flow.
Avinash: How does this really work?
AJ: To ensure trades are commission free, trades are sold to “market makers” or large firms such as Citadel. Citadel Securities is Robinhood’s largest customer, and affiliate Citadel LLC tried to bail out Melvin Capital after its Gamestop shorts cost it billions. Market makers execute those trades (sometimes at an inferior rate) and can use their privileged position to place themselves in the middle and make a profit. Crucially, in this arrangement, more trades and more volatility mean there’s more for firms like Citadel to work with. I have an excerpt here from the Financial Times explaining how it works:
Begin quote. Citadel Securities pays tens of millions of dollars for this order flow but makes money by automatically taking the other side of the order, then returning to the market to flip the trade. It pockets the difference between the price to buy and sell, known as the spread. Easy access to the market against the backdrop of wild swings in prices have led to higher trading volumes for stocks and options this year—increasing the raw material Citadel Securities uses to turn a profit. At the same time, the rise in volatility has forced spreads wider, increasing the potential income for market makers. End quote.
Now you can see how this has obviously caused many theories of collusion and less than honest activity by Robinhood to gain traction.
JR: Is there anything else substantive beyond these theories?
AJ: Well we will only know the full details in the coming months if the promised investigations by US senators bear fruit. There is a class action lawsuit that has been filed in NY against Robinhood which could also bring to light information if it goes to disclosure stage. However,Citadel and Robinhood are not new to SEC investigations. Payment for order flow wasn’t invented by Robinhood but the company’s technique differs from others who use it in the industry in that it charges a percentage of the order spread. In 2020, payment of order flow made the company $90 million in revenue for the company in the first quarter which was 70 percent of their revenues. By the next quarter it doubled to $180 million.Payment for order flow is a wonderful system that makes a lot of money for everyone involved, except the consumer. In December, Robinhood was fined $65 million by the Securities and Exchange Commission for “misleading statements and omissions in customer communications” about its revenue, but specifically around its payment of order flow process. The SEC found that customers were led to believe they were getting the best possible price for their ordersbut were actually collectively “deprived” of $34.1 million because Robinhood chose to give their orders to firms that would give the company higher revenues rather than the best prices for customers.In 2017, the SEC fined Citadel $22 million because its algorithms were short-changing the retail investors whose order flows it was purchasing.
LS: Are they doing this with other stocks too, where hedge fund managers have put money?
AJ: Yes. Redditters looked up other stocks that were heavily shorted and started to bid up their prices too. AMC – the American theatre chain whose theatres are all closed right now saw its share price move higher by 70%. AMC took advantage of it and raised some investment by selling shares. It also retired its convertible debt and the holders of the debt were able to make substantial returns whereas till a couple of months ago that debt was under water and very unlikely to be repaid. This goes back to the point we were discussing earlier – did the funds really come out so bad from this. Two funds -Silver lake and Mudrick were the largest shareholders in AMC and held the convertible debt I just mentioned. They made the trade of a lifetime from this, selling their stakes at record profits. Nokia was another share that saw a new lease of life. Its share price doubled before retracing its gains now. Lately there was intense interest in buying silver to squeeze the silver market. However, I am not convinced that was because of the members of the WSB forum. It may have been a ploy by some of the funds holding physical silver to create a momentum wave for silver by joining in the forum directly.
Trips: Okay, all said and done, so what is the learning here for both parties: Hedge fund and Retail investors.
AJ: Well,there are already some casualties.
a) Melvin capital -a hedge fund lost 100% of its value and could shut down.
b) The total amount of losses so far, appear to be 70 billion amongst the funds sitting short. It is not sure if these losses are crystallised or just marked to market.
c) Citron research, a prominent short seller, has permanently discontinued publishing short reports after losing millions themselves on the bet. Its editor also had to endure quite a bit of backlash.
d) There will definitely be retail casualties. People who got into the momentum trade but didn’t exit in time or haven’t been able to will hurt.
e) There is a huge risk in momentum trades if you don’t have visibility or access to data like the funds too. Beginner’s luck may not hold and could lead to losses which are impossible to absorb. The learning for short sellers is reinforced that while profits are finite, losses don’t have an upper limit.
f) The point that the retail investor has finally understood I think is that if the platform is free then you are the product. Your data and information areused to earn revenues. Robinhood’s users are the product. It sells information about their trades instead. It’s far more lucrative and explains why it’s willing to stop them from trading since they are not really a customer -just a data point. And that’s what I think the reddit community realised from this incident. Although it should be pretty obvious. There is no such thing as a free lunch. It is what we keep telling our corporate clients. ‘There are no such things as a no cost hedge, riskless trade or friendly bank.’
Should we wrap it up here? I think it’s been an amazing experience discussing this with you. Thanks again Trips for coordinating it. Now let’s get back to work.