Every so often this debate breaks out of the narrow confines of management consultancies and academia and impacts on public consciousness in a big way. The most recent manifestation was the massive rally in GameStop shares driven by a wave of online activism on the Reddit platform. To give the backstory, a group of online investors had been making the case for investing in GameStop, a video game and gaming merchandise retailer. Institutional investors believed there was no future in the business and a number of hedge funds had big short positions on the stock. However, a number of day traders realised that if they could force the price higher they would inflict heavy losses on the short sellers. In this way the GameStop case quickly became a cause celebre for activists looking to deal a bloody nose to the financial professionals. If one of the features of democracy is the right to protest, this event can be viewed as the investment equivalent of taking to the barricades.
One of the notable features of the GameStop saga is that it was exacerbated by the use of options. Day traders who were organising their activities over Reddit bought short-dated call options in GameStop with the result that the market makers who sold the options were essentially taking short positions in the stock. As a result the sellers of options were forced to buy it in order to hedge their positions, driving the price ever higher. This is a so-called gamma squeeze – a measure of the change in the value of the option with respect to the change in the price of the underlying security – and is an inevitable consequence of the structure of the options market (this article on Yahoo Finance gives a great overview of how the options market worked in this case). The whole affair resulted in two of the hedge funds betting on a fall in the price of GameStop being forced to cut their positions as the price climbed ever higher. In the case of one of these funds, Melvin Capital, its backers were forced to inject almost $3 billion in order to keep it afloat. One-nil to the activists.
Comes a day of reckoning
Whilst it is true that markets should not just serve the interests of the wealthy, and it is a great spectator sport to watch David winning out over Goliath, the episode does raise a number of worrying questions to which there are as yet no answers. Most obviously, do the small investors really understand the risks inherent in options trading? At the end of January there were 9860 open contracts, each one requiring the holder to buy 100 GameStop shares at prices between $300 and $320 per share. Investors were no longer merely the holder of a financial instrument – they were potential shareholders who had to find $312 million in order to exercise their option. Since the small investors did not have that kind of money (they have merely bought an option to purchase the stock, they do not have to buy it), the market makers issued a margin call. Since the investors struggled to find the funds to even meet this call, the issuers of the options closed out the position by selling GameStop stock. Surprise, surprise, the price of GameStop then collapsed thus demonstrating the dangers of an options-fuelled surge in prices and highlighting the old adage that if something is too good to be true it probably is.
Those who bought call options will lose a few hundred dollars which they may justify as a small price to pay for poking the hedge fund community in the eye. But anyone who rode on the coattails of the surge by simply buying the stock in the expectation of further gains could have suffered an unexpectedly nasty shock as the price collapsed. It was not for nothing that Warren Buffett once called derivatives “financial weapons of mass destruction.”
Another point worth noting is that the band of investors who got together on Reddit’s rWallStreetbets page engaged in the kind of collusive activity which if institutional investors did it would see them prosecuted by the financial authorities. It seems evident that some form of regulatory response is necessary. But what exactly? After all, it would merely inflame those activists who believe the system is rigged against them if actions were taken to inhibit their access to markets.
A team of journalists at the New York Times came up with a series of reform suggestions which, as they readily admit, are “conversation starters, not endorsements.” Their approach is to raise the barriers faced by institutions rather than keeping out the hoi-polloi. Amongst the measures put forward are the introduction of a transaction tax which could “reduce the attractiveness of the high-speed trading that gives sophisticated Wall Street firms a huge advantage.” In addition, there is a case for a debate about forcing hedge funds to disclose their short selling positions and forcing an end to private meetings between companies and investors which gives “the biggest financial players information that the general investing public lacks.” One of the more controversial proposals is the resurrection of the Buffett Rule that “effectively imposed a 30 percent income tax on anyone who earns more than $1 million. This wouldn’t address the markets, necessarily, but would boost perceptions of fairness in the system as a whole, which is partly what the GameStop trade is about.”
Following the events of 2008, the financial sector came to be blamed for the crash – all the more so as governments appeared willing to provide support to banks but less so to the wider economy. It is perhaps little wonder that activists have since had the financial community in their sights. Financial democratisation is a worthy goal and raising barriers to entry to the smaller investor may not be the right way to go about remedying the issues that the GameStop episode throws up. Speculation has taken place for as long as markets have existed. But failure to address the problems raised in recent weeks will simply add another layer of uncertainty to an already volatile market environment.
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