GammaStop: How market structure changed the rules of the game

Image courtesy of MrBeast

One of the world most preeminent content creators is Jimmy Donaldson, better known by his stage name, MrBeast. With a following of 52.2 MILLION on Youtube, he has continuously redefined his genre. On Saturday 17th October 2020 a seminal event took place in the “creator” content world. Some of you may be wondering what on earth this even means. Good - that’s the point. MrBeast’s Creator Games 2 featured a host of social media personalities and content creators competing in a trivia quiz tournament. If you click the link and see some of the questions you will be even more amazed at the triviality of the questions. The first Creator Games had been a similar setup but it was a rock, paper, scissors competition. Yes, you read correctly. The point is that older generations (and we mean aged 30 and up) simply do not get why 1 million concurrent viewers will log on to Youtube to watch The Creator Games. They also don’t get why 800 000 will stick around for the full 3 hour show and most certainly don’t understand why 500 000 of these viewers still will actually go to the trouble of voting for their favourite contestant. Heck, we only just barely get it because we have spent hours and hours trying to understand it by watching this kind of content.

What on earth does this have to do with GameStop? Well, in our view, it’s critical and it’s symptomatic of a shift in the power of market participants and how one group simply does not “get" what the other is up to.

As keen observers of the constant evolution of market structure we’ve found the happenings around GameStop’s stock in the past week or so fascinating to say the least.

Gamestop is a decent but fairly unspectacular video game and electronics retailer. A physical retailer in an era of ecommerce disruption. Disclaimer: We know very little about Gamestop, nor would it ever be a stock we would trade at all.

On the surface of it, the narrative of the past week could be said to be one of the retail underdogs prevailing over Wall Street, from short seller Citron Research (whose short sell call on the stock after it popped from around $20 to $40 arguably triggered the outrage – the explainer video has unfortunately now been deleted from Twitter) to hedge fund Melvin Capital (whose short positions on GME lost them enough to require a bailout from Steve Cohen’s Point72 and Ken Griffin’s Citadel).

But there is an incredible subtext to this story. We began penning this piece early in the week and our thoughts were rather original or so we thought. A battalion of angry, unemployed youngsters are stuck at home and furious with the “suits” of Wall Street getting richer while they and their families struggled. With the immediacy of Robin Hood at their fingertips and an ability to “gather” virtually on Reddit, this protest movement began in an incredibly unlikely way.

Subsequent to us sitting down with this, none other than Chamath Palihapitiya, supremely smart and a gifted orator and now social influencer, appeared on CNBC in this extraordinary interview, which if you haven't watched you really should. And it all erupted with every commentator and politician entering the fray too. This particular piece is not about that, but it’s fascinating to watch.

Back to our story about MrBeast and his Creator Games. This new generation of Tik Tok/Reddit/Youtube traders are not particularly concerned about whether Gamestop is a good business according to traditionally accepted financial metrics. Fundamentals are merely one small ingredient in their mix. To the traditional “value” focused investor, fundamentals mean everything. We are talking about two groups who speak a different language converging upon a common battleground. Funnily enough as we type, superstar creator, David Dobrik, just tweeted late Wednesday about AMC, a struggling cinema chain, and another stock lifted dramatically by this Reddit movement.

“A M C, It's easy as 1 2 3, as simple as Do re mi, A M C, 1 2 3 Baby you and me girl”

This is someone who is TOP of the celebrity food chain and with his finger on the pulse of his audience choosing to comment about stocks because he KNOWS they want it. The two worlds are now linked. It’s all just a game or is it?

How did “retail money” manage to gather so much firepower, to the extent that it overcame the scale of institutional short selling to not only prevent a price collapse, but engineer a 9x squeeze in the stock price in 8 days, including 2 days of a weekend (yes, not a typo, 9x from $40 to almost $360/share as of the time of writing)?

For us, this is a very pertinent example of how market structure has profoundly changed from the fundamentals-driven markets of the past to a flow-driven set-up that we see now.

Watch the tail, not the dog

To us, the magnitude and violence of the squeeze comes as little surprise once it became clear that far out of the money call options were the weapon of choice for team WSB. Even Chamath used them before he closed out his position and generously donated the entire proceeds to The Barstool Sport Fund for small business. In fact today (Wednesday) was the highest call volume traded on record in the US.

Source: https://twitter.com/SarahPonczek/status/135455732445996231?s=20

We’ve written about the impact that dealer hedging has on markets, making the argument that the “derivatives” market is really now the primary channel by which a market view is expressed, while the “underlying” market (the actual stock) has actually become the derivative. The tail now wags the dog.

In the case of highly liquid products like S&P 500 index options, hedging is straightforward: a liquid futures market allows most hedging volumes to be absorbed easily. But when it comes to an underlying asset that is not as liquid compared to the size of the options exposures, hedging becomes a problem.

In the case of GME (and other WSB targets like AMC Entertainment, a similarly structurally challenged theatres business where a similar feat is currently being attempted), what we’re looking at right now is a massive gamma squeeze: calls being bought triggers dealer buying, dealer buying triggers prices going up, price going up triggers more calls being bought, and Reddit helps. At the same time, thanks to gamma, as prices go up, dealers hedge more, triggering more and more and more buying. The inherent leverage in call options gives the relatively small premiums spent by these traders a magnified impact on the underlying market, triggering first the squeeze out of the short positions, and the subsequent rocketing as more buying comes through.*

At the bottom line, the key change that has happened in the stock markets here is that “retail”, previously locked out of the sophisticated world of Wall Street, has been equipped with the same tools available to most hedge fund managers. Finance has been democratised, as brokers expand their addressable market from Wall Street to Main Street. And what we’re seeing now in stocks – unfettered access to top grade infrastructure and derivatives, is not even new: in the land of crypto, shunned by institutions, the everyday trader has “stuck it to the man” and made billions just by being there early.

In a way, market legends such as Paul Tudor Jones and Stan Druckenmiller have been dumped on by the earliest of bitcoin hodlers.

More than just fundamentals

The key message here is the notion that markets are not the way they used to be, and that we need to construct investment cases based on more than just plain old school fundamentals.

Fundamental analysis is not enough to explain or even foresee the risk of such flow-driven outcomes. GameStop might be an extreme example, egged on by the great personalities and none other than the master of social media spin himself, Elon Musk and an increasingly confident Reddit community. But to a less obvious extent, the deviations from “fundamentals” are becoming ever more pronounced, and affecting not just smaller stocks like GameStop, but also the larger names at an index level.

There are flows in the market that are involuntary and driven by factors unrelated to fundamentals, and the deviations from fundamentals can be so huge and so violent that the very viability of investment managers as they used to be is at risk.

In years gone by, looking at data on positioning and flows has been frowned upon by a fundamentals-driven elite as “hocus pocus” and “reading tea leaves”, and making trading decisions on these factors was seen as “just trading”. That may have been the case then, but as we are being shown now, market structure with a convincing narrative is as important as earnings and cashflows in determining price action. The only time fundamentals matter is when other investors think that fundamentals matter and for the moment anyway that just doesn’t seem to be the case.

As managers, we don’t give ourselves the privilege of condescendingly blaming “irrational” behaviour of a Reddit “mob” for poor performance. The market is made up of its participants and the more influence the new-age investor has in this access-enabled world we have, the more old-school investors need to think out of the box. Just because this new style of investing is different does not mean it is wrong. Markets constantly evolve and there are some smart minds out there that do not belong to the establishment and look at the world through different eyes.  

Our job is to be right on the price movement of the instrument in question. If we wanted to do pure fundamental analysis we would switch to VC and private equity. That is what makes this job so enjoyable – working all of this out.

And that is why we invest in stocks and not companies.

* Footnote: Furthermore, regulatory risk limits put in place to limit risk-taking in the aftermath of 2008-2009 under the Dodd-Frank rules put limits on how much risk investment banks and dealers could “warehouse” on their balance sheets, removing a critical buffer from the system: dealers now have to hedge excess exposures in the market by law. To not get caught out on the wrong side of the trade, preemptive hedging adds one more driver of flow - in the same direction. Thus the law of unintended consequences manifests itself once more.