What started as a small group of people investing in the “underdog” turned into an all-out war with the titans of Wall Street. In 2019 the trade wasn’t that complicated. A regular dude started buying $GME shares by the thousands. He withstood a good amount of criticism but held onto the shares anyway.
It wasn’t until the summer of 2020 that investors began to realize that $GME and some other stocks held the possibility of a big short squeeze that could make them millionaires overnight. There were posts on the WallStreetBets Reddit forum talking about stocks that had a lot of short interest.
This means that people made large bets that the stock price would continue down. Wall Street sharks have long been in the game of selling the stock of companies they believe will go out of business.
New Management for $GME
During 2019 $GME worked to reorganize upper management to gain a vision of a future that included the business. They had been courting Jame Cohen, the founder of Chewy, for a little over a year. He finally joined the board in Jan 2021.
This event and the help of a cohort of Reddit users holding long and strong caused the stock price to leap over 100% in a matter of days.
This idea of quick cash caught on like wildfire, and people started buying shares and options, and here is where the convexity-complexity begins.
As you probably heard, Melvin Capital, the firm that held the largest short bet, was propped up with funds from Citadel and Point72. That aside, the short interest in $GME had been over 100% of its outstanding shares.
As people bought calls in the hopes of 500%+ returns, market makers (the people that sold the calls) joined the hordes of people going long to cover their short call positions. This is how you get a convexity squeeze, also referred to as a gamma squeeze (which happened market-wide over the summer of 2020).
Additionally, some participants that understood how the options market works were purchasing calls as the highest strike offered. Thousands of call contracts were bought at high prices, considered to be a low probability of being hit.
Take a Closer Look
Let’s say you look at three-month-out call options on the $SPY that are way out of the money. Those options are usually $0.01 or less. That means you pay $10 for 100 contracts at that position. Consider this, $SPY prices go to and exceed your strike. Yay, you earned a nice profit! The market maker that sold those calls to you will have lost all of the money that he has to pay you. For a market maker to stay in business, they have to do one of two or three things. First, if there are enough put buyers, they can offset their call selling risk by selling a LOT of puts. Another option is to purchase underlying shares to cover the move. They can also buy shares in other instruments.
How Does it Work?
Back to the effect of call buyers at high prices. The faster the stock or underlying moves into low probability price areas, the faster the option will accumulate a profit. Options that are closer to expiration will also move faster than options that have months to expire.
So, these call buyers at high strikes close to expiration understood that market makers need to cover their risk. To do so, market makers buy stock in proportion to their risk. This means, the further out the calls, market makers need more stock as the stock price rises. Overall, causing the stock price to rise faster than if this was not happening.
To this day irregular call buying remains in place. Let’s compare the 2nd standard deviation in price on the $SPY and the furthest out $GME call option volume.
You can see that over 5K calls have been bought at the $421 strike in $SPY. Note that the traded volume is 61.6M. In the $GME options chain, there are over 14K contracts betting that $GME will get to $800 in the next two days. The traded volume for $GME is 21.1M and $GME is trading in the $160 area. Clearly, people have not given up on this play.
$GME, yes, it was a mess. I would imagine that we will see more Shenanigans in the future. I don’t know what will happen with this stock.If the new management does well they could stand to be back on top of things again in the near future. Learn more about trading with MrTopStep.