What's Going on With GameStop and Blackberry?

The story of the last week or so in financial markets has undoubtedly been the remarkable rise of Blackberry (TSX:BB) and especially GameStop (NYSE:GME):

Source: S&P Capital IQ

Source: S&P Capital IQ

The answer to the question "what is going on here?" has a few answers of increasing complexity that all give you a good view into how the market works today.

There's a Lot of Retail Traders and They're All Buying

We'll get into some fancier explanations down below, but none of this happens without the incredible surge in retail investor participation we've seen in the last year. The coronavirus pandemic sent a lot of people home, and with sports betting and casinos switched off for months and the widespread availability of discount brokerages offering trades at little or no cost, a huge amount of money poured into the stock market. The collapse in fixed income yields we saw early in the pandemic didn't hurt either, nor did the globally-coordinated program of money printing.

Retail investors with discount brokerages love to trade but don't have a relationship with seasoned financial professionals like your friends at Canaccord Genuity, so they end up congregating in online communities. These communities (like wallstreetbets now, or RagingBull back in the 90's) tend towards consensus, and with 2.5 million people reading wallstreetbets these days, a consensus position can command enormous flow. 2.5 million people with free trades and a few thousand dollars to spend can move thinly traded zombie stocks like GameStop and Blackberry pretty quickly.

Specifically They're Trading Derivatives, Which Amplifies Their Effect

Another key development of the last few years has been the offering of free options trades through online platforms like Robinhood. Derivatives are an extremely good way to gain cheap and concentrated exposure, which amplifies the effect of a retail trader on the market. Back in the day, Johnny Wannabewealthy could only gain $5,000 in exposure with his $5,000 in cash. An option trader can get many times that, particularly if they're willing to buy options that have a very low probability of expiring in the money. That's what many, but not all, of this new generation of retail traders are doing: using high-powered derivatives to give themselves outsized exposure to the movement of a stock price.

How this affects the market for common shares is a little complicated, but basically boils down to this: it's someone's job to sell these options. That is the role of market maker, and if millions of people all buy options in one direction on a given stock, the market maker has to hedge this risk. In this case, they do that buy buying the stock themselves (more details below) and that can cause a bit of a positive-feedback loop.

Even More Specifically They're Buying OTM Call Options, Which Can Force A Market-Maker's Hand

Any time a market maker sells an option, they balance their risk. If you walk into their shop tomorrow and buy an extremely out of the money call option on, say, Walmart, a stock that doesn't move much, they'll buy a very small number of shares -- equal to the size of your contract multiplied by the probability that contract will create a liability for them.

But if tomorrow the price of Walmart goes up, that probability changes, and now the market maker has to go buy some more shares to balance their exposure. If there aren't many shares available, they'll pay out the nose for them, regardless of what they think about Walmart stock. They're just trying to balance their risk from market-making, not read financial statements.

Usually this fight is asymmetrical and the problem goes away, since the market makers don't care about fundamentals and most investors do. If the price of the stock doubles without the company changing much, people who have read Benjamin Graham's The Intelligent Investor will tend to sell it if they own it or stop buying it if they don't. That alleviates upward pressure on the price of the stock, things return to normal, and the market maker continues to clip its profit along the way.

The nightmare scenario for the market maker is when these things happen simultaneously:

  • There aren't a lot of shares available, for example if someone is shorting it heavily;

  • There's demand for call options with higher and higher strike prices, which the market maker has to sell,

  • The people on the other side of the trade haven't read The Intelligent Investor, don't want to, and have organized themselves into a community that takes pride in being unintelligent investors.

That's all happening right now, to GameStop and Blackberry and a handful of other "meme stocks." The community identifies stocks that could create problems for the market maker, pile into them with everything they've got, and hope it causes a melt-up. 

What's a "Gamma Squeeze?"

We've already described it to you. "Delta" is the sensitivity of an option's price to changes in the price of the underlying, and it's also the probability than an option will expire in the money. "Gamma" is the sensitivity of an option to a changes in it's delta.

Thinking in greeks and calculus is a great way to make your head hurt and not understand things better. Keep it simple: a gamma squeeze is where the probability of options expiring in the money keeps increasing, so the market maker has to keep adding to its hedge position, pushing the price of the underlying even higher and making the problem worse.

So What Do We Do?

To be clear: this is not investing, this is speculation. If you want to have fun and feel like you're a part of history, go ahead and put your gambling budget on GameStop or Blackberry or whatever these people pick next. If you're not a gambler, and you already own Blackberry, now is maybe a good time to sell. When a stock price quadruples and the company tells the regulator "we don't know why this is happening but it's nothing we're doing," that's a good exit point.

If you're not a gambler and you blew out your Blackberry stock a long time ago, just stay away, but understand what's happening. It's an important market dynamic that could just get stronger and stronger as more retail traders pile in. Also: take a look at any short exposure you have, and try to make sure you're not going to be on the wrong end of a disastrous melt-up.


If you'd like to talk about these events or discuss your portfolio, don't hesitate to reach out to us at 604.643.0101.

Cash Management Group

604.643.0101 | Email us

 

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