What the Tech? A look at GameStop, Algorithmic Trading and Beyond

By now everyone is aware of the epic battle involving Gamestop, hedge funds and WallStreetBets.

On the topic, I saw this video that speculated the role of algorithmic trading as one of the causes:

Based on that, I searched for any hint of algorithmic trading. The best I could find was the following:

"Some hedge funds likely hopped on for the ride, though. Many use what’s known as quantitative algorithmic trading, meaning the process is automated, allowing them to quickly catch any big waves.

"That's exactly what they do. They look at the momentum, and they look at the order size and the amount of activity and absolutely they ride that momentum,” Shelly said. “They're professionals, and they're experts at this business, and to think, long term, you're probably going to do better than they are is kind of a fool’s game.”

The question is how much of this amplification versus direction? Richard Coffin of the Plain Bagel, seemed to hint it is more of the latter rather than former. 

So let's step back and see what was actually going on. 

In any trade, there are always two sides to it. And so what are the two opposing forces in this saga?

This started with the hedge funds shorting 139% of Gamestop's stock:

"GameStop stock equal to 139% of its available shares has been borrowed and sold short, a bearish position showing mark-to-market losses of over $6 billion year-to-date, according to data from financial analytics firm S3 Partners. That figure is little changed since last Thursday’s 141% short-interest reading, even though GameStop shares have surged roughly 78% in the past two days alone."

The hedge-fund lost so much money that they had to get a $2.75 billion bailout from fellow hedge-funds:

"Hedge fund giants Steve Cohen and Ken Griffin are joining forces to bail out a fellow trader whose positions in runaway stocks like GameStop have been getting hammered. Griffin’s Citadel and Cohen’s Point72 Asset Management are investing a combined $2.75 billion into Melvin Capital Management, which has seen its recent bets on stock declines thwarted by a small army of investors with get-rich-quick dreams. The fund, run by ex-Cohen lieutenant Gabe Plotkin, is down 30 percent, the Wall Street Journal reported."

On the other side, were the now-infamous WallStreetBets (WSB) group on Reddit that started to push the stock up. This has been reported in the press from multiple sources. Here is a sample:

Bloomberg: "Give credit where it’s due. In their frenzy, WSB’s cocky hordes have managed to turn the tables in a game short sellers invented, spinning gold from the complacency of others. Before this year, GameStop was a cash register for bearish traders, who borrowed and sold more shares than the company issued. Hedge funds had been winning so long that they overlooked the tinderbox they were creating should sentiment turn."

WSJ: "Online forums like Reddit’s WallStreetBets are full of traders boasting that they are beating up the big investors who normally control the market. It is an ironic twist, or a sign of their lack of understanding, that they equate short sellers with the Wall Street establishment."

CNBC: "In the Reddit forum “wallstreetbets” with more than 2 million subscribers, rookie investors encouraged each other to pile into GameStop’s shares and call options, creating massive short squeezes in the stock."

Also, see Mad Money's Jim Cramer thoughts on this. The video also includes comments from Herb Greenberg, CEO of Pacific Square Research, who goes as far as to say this may be illegal. And this is quite rare to have such a crowd to get regulators involved. The point being is that this type of talk probably indicates the large institutional investors have been caught by surprise by WSB investors.

But is this solely about "momentum" or is there something more from the fundamentals side?

Chamath Palihapitiya pointed on CNBC, there are some disagreement on the "fundamentals" of Gamestop

What are those fundamentals? 

One is that (according to one analyst) that the sales of the Sony Playstation 5 would give GameStop a boost. The other, according to Bloomberg, was that there was new leadership on GameStop's Board:

 

"But some people think GameStop is primed for a turnaround. One of those people is Ryan Cohen, the former chief executive officer of Chewy Inc., the online pet-food retailer. If you can sell pet food online, you can sell video games online. GameStop does sell some video games online, and could probably do more of that and less with the stores in malls. Cohen’s investment vehicle owns about 12.9% of GameStop, which he started buying in August, when the stock was in the mid-single digits. In November he sent a stern letter to GameStop’s board of directors, reminding them of what a bad job they’ve done, asserting “that GameStop has the flexibility to evolve into a technology-driven sector leader,” and urging the board to try to do that. Two weeks ago, on Jan. 11, GameStop announced that Cohen and two of his friends from Chewy would be joining GameStop’s board. “Their substantial e-commerce and technology expertise will help us accelerate our transformation plans and fully capture the significant growth opportunities ahead for GameStop,” said GameStop."

And so that battle lines were drawn. 

According to Bloomberg, there were two things pushed the value of the stock upwards. 

First, since the hedge fund had shorted more than a 100% of the shares that exist, they really needed to buy back those shares. But once the shares started drifting upwards, the more they bought, the higher they got. This is what is known as a "short squeeze". 

The second was that the WSB investors used call options: "If you are a retail trader looking to gamble on a stock, you can buy call options to get leveraged exposure to the stock. For instance, last Tuesday (Jan. 19), you could have bought a $50-strike call option on 100 shares of GameStop stock expiring this coming Friday (Jan. 29). Bloomberg tells me this option would have cost you about $3.35 per share, or about $335 for a 100-share option contract; the stock closed that day at $39.36. If you sold the options on Friday (Jan. 22), when the stock closed at $65.01, they were worth $18.16 per share."

But it seems here is the key part that essentially enabled the WSB investors to use the options as asymmetrical warfare against the hedge funds. They bought so many call options that the "market makers" that sold them the shares had to buy the shares because of something called a "gamma squeeze", which Bloomberg explained as follows: 

"Meanwhile the market maker who sold you the options would have hedged its option exposure by buying about 40 shares of GameStop stock, for about $1,575. (This—the fraction of the underlying shares that the market maker buys to hedge the option—is called “delta.”) Your $335 of option premium caused $1,575 of stock buying." [Emphasis added]

In other words, the risk of the stock going up means that the market maker has to buy actual stock to hedge their risk. And so this caused the GameStop stock to go up. 

Also, tweets from Elon Musk and Chamath Palihapitiya (both billionaires) further assisted the rally of Gamestop stock.  

And this takes us back to the trading algorithms. They are programmed and designed to take advantage of such "momentum" and so that is a basic strategy of these bots. 

Although one can assume they played a role, it does seem that the WSB investors were able to find a chink in Wall Street's armour and drive a bus through it. 

This is not investment advice. 
So do not take it that way. 

Author: Malik Datardina, CPA, CA, CISA. Malik works at Auvenir as a GRC Strategist that is working to transform the engagement experience for accounting firms and their clients. The opinions expressed here do not necessarily represent UWCISA, UW, Auvenir (or its affiliates), CPA Canada or anyone else