While stocks represent ownership of underlying businesses and should (and over the long-term often do) reflect the fundamentals of those businesses, the two can become disconnected.
Here, forget everything you know about fundamental analysis. Technical analysis will also be of little use because you’re not going to glean anything of value by looking at a chart that is simply a straight line up for hundreds of percentage points.
When GameStop was at $4, an argument could be made that the Grapevine, Texas, tech retailer was a so-called deep-value name, with prominent value investors such as Steve Eisman having previously taken long positions.
But this stock left the realm of deep value (or anything remotely resembling value) many points ago.
This move was all about market mechanics.
Consider the setup. $GME is a brick-and-mortar retailer struggling to survive in a digital world. As a result, the shares until recently had been on a steady multiyear decline, leading to a low market capitalization, low-dollar-per-share trading price and massive short interest.
(That short interest -- bets that the stock would decline -- had exceeded 100% of the shares outstanding, though that may not be the case after the short squeeze* we saw on Monday.)
These three factors mean three things:
a) Less money can move shares because each buy order represents a greater percentage of the capitalization.
b) Call options are cheaper on a dollar basis and leverage is easier to come by even if an investor has a small bankroll. Thus many small bankrolls can enter the trade. Those $2,000 Robinhood accounts suddenly become a force to be reckoned with, even if they couldn’t afford a single call option on shares of a $100 stock with the same market capitalization; and,
c) At some point if you press it hard enough, you’re going to get a short squeeze when those betting against the stock can’t take it anymore or run out of money and are forced to buy shares to close out their trades.
Now on point b, you might be saying, "So what? They’re buying far out-of-the-money call options that can’t affect the actual stock price."
But what investors must remember is that someone is on the other side of those trades, selling those call options. I'm not going to get into things like delta hedges and gamma squeezes. Just know that if the sellers of those call options want to hedge their risk, they must buy shares to ensure they have something to deliver if the stock runs.
So, the purchases of those cheap out-of-the-money calls have a ripple effect. They create more demand for actual shares if only to enable the counterparties to hedge out the calls they sold to open the trades.
The next piece of this investing puzzle to account for is how the market and, more important, its participants have changed in recent years.
The most well-known factor is Robinhood, which put the nail in the coffin of trading commissions and put the ability to day-trade in everyone’s pocket.
The company's gamified trading app is simple and beautifully designed -- even if its lack of many features would prompt any serious investor to consider it a deal-breaker.
Robinhood's attractive and easy method is especially important when it comes to placing options orders. And these are key to the GME story.
Yet another phenomenon that only recently has been garnering more attention is the presence of online chatrooms. Yes, we’ve seen these before -- but the type of investors leveraging them has changed.
(The leading current chatroom is Reddit’s WallStreetBets subreddit. Bear in mind that political correctness there is nonexistent. WallStreetBets doesn’t claim 2.1 million users. It claims 2.1 million degenerates, considering the term a badge of honor for this Wild West group of gamblers. So if you’re easily offended, you may do well to steer clear of it.)
While the older trading chatrooms had been used more for discussing a fundamental/technical investment thesis, today’s version is more about high-risk/high-reward plays, memes, and the view that it doesn’t matter if you win or lose just as long as you go big – the more leverage the better.
And this is the mentality at work in a stock like GME.
So, what do we have?
1) a low-market-cap, heavily shorted stock with a dollar price low enough to make leverage dirt cheap (the dollars that must be put up to buy call options);
2) a rabid group of retail traders that throw caution to the wind and think that the only thing more honorable than a monster gain is a monster loss. (Sure, you ruined your life financially, but the community got a laugh out of it and you got upvotes, similar to Facebook (FB) - Get Report likes.) And,
3) a shutdown keeping people indoors and a little “stimmy stimmy” from the federal government (even if you haven’t lost your job or taken a pay cut).
What do you get when you mix the three? You get a short squeeze of epic proportions and a blow-off top like the one we saw Monday.
Luckily, this issue is likely not large enough to harm the broad market. But it is something investors should be mindful of, as it speaks loudly to the current trading environment.
If you want to avoid being on the wrong end of this kind of insanity, keep these dynamics in mind the next time you look at a stock that has a small market cap, low dollar value and heavy short interest.
Another example? Look at shares of AMC Entertainment Holdings, (AMC) - Get Report which has more than 20% short interest and a low dollar price following years of declining fundamentals and pandemic-induced shutdowns. It’s up some 30% on Monday despite news of a $917 million capital raise.
Of course, for investors who read this and hope to jump on the crazy train, I salute your courage. All I ask is that you remember what you’re signing up for.
This is not investing; it’s walking up to the craps table in an unregulated casino hoping for a hot streak.
Nothing wrong with that -- but investors should know what it is and what it is not. And above all know exactly how much you’re risking on whatever position you choose to enter.
*How does a short squeeze work? Short-sellers borrow shares and sell them, betting that the price will decline and they'll be able to buy the shares back at a lower price, return the shares to the lender, and pocket the difference. But when the share price instead rises, the short sellers must buy the shares back at the higher prices to return them to the lender, causing losses. These purchases can drive the share price yet higher, and this situation can then repeat itself. The losses can become dramatic unless the short sellers abandon their bets.