GameStop (GME) stock has gone from trading for under $5 per share less than six months ago to hitting a high of $159.18 just yesterday.
For those unaware, GameStop, a primarily mall-based retailer of video games, has not seen a dramatic improvement in the outlook for it's business. In fact, GameStop has had a rough go of things recently with the retailer planning to close more than 1,000 stores by the end of March. There are many reasons for GameStop’s falling fortunes, chief among them being the rise of digital video game sales at the expense of physical copies.
So why is GME stock soaring?
The stock had been rising for a while, but the massive rise in share price that began last week was prompted by a confluence of factors, namely Reddit, Robinhood a short squeeze and delta hedging.
Wallstreetbets
Brokerage startup Robinhood has allowed many more investors to engage in day trading due to its commission-free mobile-first platform. Robinhood essentially forced most of the major brokers to eliminate their own trading commissions in order to stay competitive. Additionally, the minimum requirements for day trading on the app are far lower most other brokers previously set, allowing far more people to trade in and out of stocks multiple times a day than ever before. Finally, Robinhood’s simple and easy to use design brought more investors into the market that previously found trading stocks a more daunting task.
Robinhood might have helped GME’s rise with its accessible trading platform but it seems a forum on Reddit known as r/wallstreetbets was the driving force behind the spike. The popular subreddit has more than 2.3 million members. WSB as it is known, has pushed stocks around before with the community not being particularly fond of risk management and instead going for a more YOLO style of investing. Big rallies in stocks like DraftKings (DKNG), Nio Inc. (NIO), Palantir (PLTR), and Tesla (TSLA) were all cheered on and participated in by WSB.
To be clear to investors, there isn't much in the way of analysis by these posters when making an "investment" decision. It's essentially a gambling chat room where people brag about massive gains, and losses. GME is just the latest of many stocks to post price gains after becoming popular on social media, but so far, it seems to be the biggest, which has only gotten it more attention, and attracted more people following the herd.
Additionally, many are "investing" in GameStop to stick to the man. They see it as a way for small individual traders to strike a blow against hedge funds who are holding the shares short. Individual investors banding together to strike a blow against hedge funds is a new phenomenon in markets, and it isn't clear that many of these investors actually believe GME has a bright future.
Short Squeeze
GameStop's falling fortunes had lead it to be near the top of the list of most-shorted stocks. Short interest was actually more than 100% of the stock's float, meaning that some shares had in effect, been sold short more than once. Short selling, which is a way to bet that a stock will go down, follows the investing adage of buy low and sell high, only tries to execute those maneuvers in reverse order. A short seller borrows shares from an investor with a long position and sells them. The goal is for the stock to fall, so the short-seller can then buy the shares at a lower price and return the borrowed shares.
This strategy runs into problems when the stock price rises. Short sellers often face increasing borrowing costs and margin calls as their losses grow. Short sellers rushing to close short positions (by buying the stock) can cause prices to jump sharply, particularly in heavily shorted stocks like GameStop.
This seems to be one of the factors that caused the stock's run to really accelerate on Friday after the Redditors started buying it.
Delta Hedging
A low share price, relatively small float and high short interest means it doesn't take a lot of money to push the stock price around. Once the stock starts going up, and the short squeeze kicks in, other factors can kick in to really pour gas on the fire.
One of those factors is what's known as delta hedging. As GME started to rise, lots of traders bought call options on the stock, specifically, short-dated out-of-the-money call options. These options are often very inexpensive, but can gain value very quickly as the stock rises (this is measured by the options greek known as Delta).
It’s common to think that buying far out-of-the-money calls won't affect the actual stock price but this is where delta hedging comes into play.
Delta hedging reduces risk for the call seller, who can lose money if the options they sold end up expiring in the money. Essentially, the market makers who sold those out of the money options needs to buy shares of the stock to cover their potential risk. Conveniently, Delta, or something close to it, is roughly how many shares are needed to hedge this risk.
So as GameStop rose, market makers had to buy additional shares to cover their potential losses on the option they sold. With thousands of short-dated options contracts on the board, the number of share needed to hedge them got pretty high as the price climbed, adding even more buying pressure to the market.
Where Does GME Go From Here?
With all that said where is GME headed in the long run?
No one can know for sure but it's pretty clear that GameStop is massively overvalued at the moment even if it had some deep value back in mid 2020.
However, there are many stocks that remain overvalued and haven't shown any signs of slowing down. Stocks can be overbought and remain that way for a long time even if everyone knows that as traders simply speculate on future price movement with no attention paid to fundamental factors.
It's impossible to know when the stock will stop going up, but many of the factors that helped turbo charge the rise can easily contribute to a rapid move in the opposite direction.
