The COVID lockdown era will be remembered for many things, not least for the explosion of interest in the stock market across all reaches of society.
For one reason or another, March 2020 saw people with considerably more time on their hands and – for millions of Americans – stimulus checks. Following the sudden crash of global stock markets, and the unprecedented fiscal and monetary intervention by governments that spurred a rapid rebound in asset prices, many took the opportunity to put some ‘skin in the game’ and enter the world of trading.
Indeed, the lockdown period bred a newfound interest in markets among retail (non-professional) investors, in part due to a proliferation of online trading platforms, many of whom grant access the markets without charging customers out-of-pocket fees. The Economist reports in 2019, 59 million Americans had an account with one of the top seven brokerage firms. Today that number is closer to 95 million, and whereas retail traders would have normally made up about 25% of trading volumes, the lockdown era saw that proportion swell above 40%.
Emblematic of the rise of the retail trader is the historic “short-squeeze” of GameStop. By now, even those who do not follow the daily financial news cycles recognize the name GameStop, not just for the little video game stores we see at the mall, but for the meteoric rise in its share price – 2,000% in two weeks – following one of the most infamous short-squeezes in living memory.
What happened there? To understand the GameStop trade, and other ‘meme’ stocks that saw unusual action through the lockdown era, one has to understand stock options.
Options – A Brief Introduction
Trading options is a way to gain exposure to the price movements of a stock without actually buying the stock. Traditionally, options are used by investors as a means of insuring against downside investment risk, of generating income for those selling options, and they are also attractive because they can be used opportunistically to gain exposure to a stock at a fraction of the cash outlay required to buy the stock outright. For context, Amazon trades around $3,300 per share these days – a nice chunk of change for the average American. Rather than buy a share outright, that same investor can trade short-term options based on 100 shares for less than $100 and still participate in the ups-and-downs of AMZN up until the option’s expiration date. Making options trading easily available to investors is one way online brokerages have earned impressive profits through the lockdowns, simply by providing the facility for more people to engage in more trading on the platforms.
To be clear, an option is a contract. The owner of an option pays a premium (the cost) for the right to buy (“call”) or sell (“put”) a security at a specific price up to a specified date. The seller of an option collects the premium from the buyer and has an obligation to buy from or sell to the option holder at the specified price up to the expiration of the contract. Option contracts are based 100 shares of the underlying security, so there it allows investors to take on greater exposure than transacting in the underlying shares.
Conceptually, the transaction seems straightforward. In practice, “optionality” is one of the most complex and widely-studied topics in finance, the basis for scores of textbooks and academic research—and why Wall Street pays handsome sums to the advanced mathematicians who occupy desks in banks and hedge funds. Option prices are extremely sensitive to the volatility of the underlying security’s price as well as the passage of time – the closer you get to the expiration date, the less valuable the option. Intuitively, this should make sense because it should be easier to predict a change in value over the short term, whereas an investor would pay a higher premium for certainty over longer time horizons.
The GameStop Trade
That is not to say that option trading is exclusive to the financial elite. On the contrary, the GameStop (GME) trade of 2021 is one that will go down in history as the time when an army of non-professional investors embarrassed some of Wall Street’s highest-paid talent by exposing a risky option trade, piling in on the other side of the trade en masse, and driving up the price of a stock the rest of the market had bet was going to go down.
Melvin Capital, a hedge fund who lost about half its value after the dust settled, took the “short” position on GameStop while using put options as a means of locking in a specified price. In other words, they predicted it would be more profitable to apply leverage by selling shares it didn’t own. At a glance, the trade may have made sense at the time. In the wake of widespread lockdowns, many retail businesses similar to GameStop were buried by mandatory store closures, and GME traded near zero.
Things got interesting when retail traders, using publicly available information and online forums like Reddit, saw Wall Street’s short position as an opportunity to rally thousands of buyers to take the other side of the trade and squeeze the professionals. By aggressively buying GameStop stock and options, driving up the price and hence the payout that Melvin and other short-sellers were on the hook for. There suddenly being more buyers than sellers in the market, coupled with the multiplier effect of widespread options trading (remember a contract is based on 100 shares), exacerbated the rate of price change. As more and more casual investors saw how much money was being made in a matter of minutes, much of the trader nation jumped on the bandwagon as the chart went vertical.
Lessons Learned
It must be acknowledged that there are multiple layers to the GameStop story and other “meme” stocks emblematic of the market euphoria that has helped drive stock indices head and shoulders above their pre-lockdown readings. While many cheered the victory of Main Street over Wall Street in the GameStop trade, there were plenty of other stories of how inexperienced investors, not fully understanding the nature of the risks involved trading stocks and options, experienced devastating losses.
On the one hand, it’s good to see people educating themselves on the workings of financial markets and taking a closer look at their investments and financial planning. But when it appears there is easy money to be made, and droves of people without investment backgrounds rush to take advantage, conditions can be created where undisciplined flows of capital can distort market prices and provide a false sense of security. Many have indeed learned the hard lesson that a stock’s price does not always reflect the health of the underlying business, but rather the herd mentality of millions of market participants.
Overall, we find the increasing interest in financial markets and investing to be a welcome and healthy development for the country. During a time where the outlook for traditional pension plans and social safety nets are less certain, the average American is increasingly responsible for securing their own financial futures. That seems like a tall order for most people, especially so considering we don’t learn the lessons like that of GameStop trade in school. At HBKS we focus on building sustainable portfolios to build wealth over the long run, and as always, welcome questions and conversations that serve to educate and better equip our clients to get the big financial decisions right.
IMPORTANT DISCLOSURES
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