Can GameStop Crash the Market?

Here’s my take on the recent market madness and what I’m doing in my portfolio.

So I happened to drop off the face of the Earth at the exact time that the market goes nuts. I spent the last couple hours getting up to speed on the GameStop drama, and I decided to type up a newsletter to outline the potential contagion risks.  

What could appear to be an isolated event between “Diamond Hands” retail traders trying to punish “corrupt” hedge funds might actually be the kindling that sets us up for a sharp draw down. 

So, if you’re not up to speed on why the market is going nuts about GameStop, here’s my 60 second catch up. 

A bunch of retail traders inside a Reddit forum called Wall Street Bets devised a plan to take advantage of the massive short interest in GameStop. The amount of shares sold short were actually higher than the total public float. 

So all of these retail traders began to buy deep out-of-the-money calls in GameStop.  This forces the dealers (the market makers who match buyers and sellers) to buy shares in GameStop as a hedge to the amount of calls they were selling. 

The set up then became, massive short interest (people betting the stock will go down), huge volume of purchasing pressure from the dealers and Reddit traders, and add on top that GameStop executives were also buying. 

All of this caused a huge increase in the price of GameStop in a short amount of time. But, the story gets crazier. 

Last week, Robinhood made the decision to limit trading in certain “meme stocks” like GameStop, AMC, and Nokia. This riled up the Reddit traders as they screamed the “big guy” is stopping the little guy from making money. 

That narrative is false, and actually the reason why I’m writing this newsletter now instead of immediately showering after getting home from my backpacking trip. 

Robinhood did not limit trading because they wanted to help out Melvin Capital (the fund who lost $4B being short GameStop). Robinhood limited trading because they were being forced by the dealers to come up with massive amounts of collateral to cover all the positions their customers were taking. 

Markets get cleared (buyers matched with sellers and money/shares exchanged) through a group of large funds who create a clearing house. All of these funds put in large amounts of collateral to make sure that the plumbing of the system never runs out of cash. This is what is commonly referred to as liquidity. 

As the price and volatility of GameStop increased, the members of the clearing house required Robinhood to not only raise their margin but to settle trades immediately. Usually brokerages have two days to settle trades and send the shares/cash. But, because of the increased volatility and risk now the clearing house members demanded cash immediately. 

Well, Robinhood has now tapped their credit lines to the max and raised about a billion dollars to increase their margin with the clearing houses. 

There’s not some conspiracy by Robinhood and the major hedge funds to punish retail traders. Robinhood didn’t have enough capital to be able to clear all the trades with the clearing houses and that’s why they raised all of that money and limited trading. 

This is a liquidity event inside Robinhood. And, I’m concerned that this liquidity event could spread and ding the market right at a time when it’s fragile. 

This GameStop saga is not over. Since more than 100% of the total float was sold short the funds and traders who still hold a short position can be on the hook for open-ended losses. They may never be able to buy back the shares they sold. Add in the dedicated holders of GameStop and we could be entering a perfect storm of risk-off. 

These Robinhood traders might actually have the power to break Robinhood. If the price and volatility of GameStop keep going up, Robinhood will be required to raise even more cash to cover their margin requirements. If Robinhood is not able to raise enough cash who knows what could happen. We might actually have a liquidity event where customers lose their money. I’m not saying that’s the most likely scenario, but it’s possible. 

At the same time, hedge funds who are short GameStop are suffering big losses at the same time as total market volatility is rising. Their VAR (value at risk) formulas are going to require them to draw down leverage. That simply means they will need to raise cash by selling. 

VAR = calculation by which a fund is allowed to take more risk (leverage)

There’s an unprecedented amount of leverage in the market right now. If the market breaks down further, we’ll see the VIX rally even more. 

And we could enter a reflexive loop of selling pressure. 

Market sells off, VIX rises. 

VAR increases as VIX rises, funds need to raise cash by selling. 

Market sells off more, VIX rises more, and you see the reflexive feedback loop similar to what we saw in March 2020

Hedge funds have a lot of risk right now. They’ve taken on a lot of leverage. Long options positions are at all-time record highs. 

And this creates even more reflexive selling pressure if the market continues to sell-off next week and the VIX rallies even more.

See, the options clearing community needs to hedge every long options contract by owning stock. If the market starts to fall the dealers will then sell the stock in proportion to their risk which will further add to the potential cascade of selling pressure. 

All of the pressures are creating a higher risk for a large, fast, and vicious move lower. 

We’re at a precipitous crossroads right now. The risks are very high for a sharp sell-off fueled by this reflexive loop of hedge funds needing to raise cash because they’re over-leveraged. 

Something interesting that did happen last week is that during all the volatility and the sell-off treasury yields went up. Usually, yields will go down as more people buy treasuries as a safe haven. 

But in this scenario the clearing house members could’ve been selling their treasuries to raise cash to cover the increases in volatility. 

So let’s explore what can happen if next week we see a sharp sell-off fueled by the hedge funds needing to raise cash to meet their VAR requirements…

Sell-off could bleed over into some of the retail favorite names. Then, as those  options go either out of the money or less in-the-money dealers will begin selling their shares (remember, we’re at record high numbers of open options contracts on popular retail names). 

But, we also have a market set up where mutual funds have record low amounts of cash and low exposure to bonds. They will be forced to sell equities and buy bonds if the market begins to drop. 

Then, add on that margin is at a record high. There’s more leverage in the market right now than at any time in history. This is part of the speculative mania we’re seeing right now. 

This is a potential liquidity event being set up. And we could see a domino effect as all of this speculative froth gets unwound in rapid order. 

So, what am I going to do about it? 

I think we’re all aware that the market is a bit frothy at the moment. We still have massive damage done to the Main Street economy from Covid, lingering threats from three new strains of the virus entering America, and a fragile market set up. 

I’m going to lower my risk in the next week and take some gains off the table. I’m not going all to cash, and I’m not going to aggressively short the market. 

But what I will do is buy bonds. I’m going to buy some calls on TLT. My bet is that bond yields fall much lower and potentially even go negative. I’m looking at the March 160 calls, the 165 calls or even the April 170 calls. 

Will I enter GameStop and ride that wave a little? Maybe. It depends what happens on Monday. If you’re looking for just how high GameStop could go check out the story of VW’s massive short squeeze in 2008. 

So that’s my take on the market madness of the last week. If you have some other insight or opinions, leave me a comment or respond to this email. 

Next issue comes out on Friday.