GameStop – The Second Surge: Anatomy Of A “Gamma Swarm”

BRAZIL - 2021/02/18: In this photo illustration a GameStop logo seen displayed on a smartphone with ... [+] the stock market graphic in the background. (Photo Illustration by Rafael Henrique/SOPA Images/LightRocket via Getty Images) SOPA Images/LightRocket via Getty Images

GameStop GME is not following the script. Despite the confident predictions by almost all the sideline observers (including myself) that the January frenzy in GME shares would end predictably, and badly… this “Stonk” has suddenly surged a second time, embarrassing the conventional wisdom once again.

GME - The Second Surge Chart by author

When GME first erupted in January, I thought it looked like just a clever way to accelerate a conventional short squeeze. (The mechanics of a short squeeze, and the “gamma” accelerant using call options, are described in my previous column.) On that basis, I expected that it would soon deflate and “return to normal.” The battlefield would be littered with the carcasses of small investors who bought at the top. We’d hear the distant sound of champagne popping in the proud towers of Wall Street and Chicago, and the scolds in the press would treat us to another round of lectures on thrift and the Madness of Crowds.

That’s not what happened. The stock did come down as low as $38, but the deflation didn’t stick. As of this moment mid-day (March 10), GME is again trading above $300 a share. [Things are moving fast. See the Update at the end of this piece.]

This latest surge is revealing something truly new. Another “gamma swarm” – this time in its pure form, without the added “fuel” of an over-extended short position (the shorts were substantially cleared out by the January episode).

In this column, I will examine this second surge in detail. It is the type-specimen of a new kind of market maneuver, which will establish this event as more than an anomaly. The “gamma swarm” phenomenon looks like something to be reckoned with, a new trading strategy that may require many other market participants – short sellers, regulators, market makers, clearinghouses, certain hedge funds, many conventional investors – to make significant accommodations.

My previous analysis highlighted two components of the the January eruption: a short squeeze, and a “gamma squeeze.”

There seems little doubt now that the top of the January surge was the result of a successful rout of several major short-sellers, who had become complacent (it would seem) with their thesis and taken on too much risk. At the beginning of the year, the short interest in GME — that is, the percentage of the company’s stock that had been sold short – was at least 68 million shares. The entire public float (that is, the shares freely trading in the market, excluding shares held by insiders) comprises 45 million shares. A short interest in excess of the float is not impossible, but it is highly unusual.

And unstable, as events showed. Shares sold short all have to be bought back at some point (unless the company goes completely bankrupt) – so one way to view this was as an enormous reservoir of pent-up demand, a “coiled spring,” which if somehow triggered could propel the stock sharply upwards – inflicting huge losses on the short sellers.

As described in the previous column, however, successful short squeezes are historically very hard to engineer, and therefore very rare. What made the January surge in GME work was the addition of an innovative new tactic.

The mechanics of a gamma squeeze are complex (see the earlier column for details), and I doubt they are fully understood yet. Even the professionals failed in many cases to anticipate this development, which is why some of them lost a great deal of money.

The basic idea can be stated in simple terms. It involves the use of options, specifically Call Options (that is, options to buy shares in the future at a defined price – called the strike price) to drive up the price of the shares. It works because when a trader buys a call option, it creates a risk for the counterparty who sold that option. Without further measures, if the shares rise above the strike price, the option seller will have to acquire those shares in the open market, at a loss, to fulfill the contract.

There are many ways to hedge this risk. The net-net of the process, though, often requires someone to buy a share of the underlying stock – the call is converted at some point into a covered call.

“The market maker has sold you an option that goes up in value as the stock goes up. The more the stock goes up, the more the market maker owes you. It hedges this by buying something else that goes up in value as the stock goes up—specifically, the stock itself.”

The other key fact is that options are much cheaper to buy than shares. In the example developed in the previous column, based on actual market pricing, a typical 2-week call option for Tesla TSLA cost just 2% of the price of Tesla’s shares at the time. This means that “ordinary investors” - retail traders – can more easily participate. And if they can coordinate their option buying, they gain huge leverage by forcing the option sellers to buy shares – putting upward pressure on the stock.

So, essentially, in the January surge, the pre-existing short interest in GME was like dry tinder, ready to burn but hard to ignite. The gamma squeeze – using options, with their inherently enormous leverage for creating pressure on the buy-side – was like adding gasoline and tossing a match. Boom.

What is Different About the Second Surge

The new surge took off quite suddenly around 2:30 pm on February 24.

The stock had been quiescent for the previous 2 weeks, drifting down gently. We all thought it was the calm after the storm. But then, on the 24th, the share price doubled in the final 90 minutes of trading, and then doubled again in the first half hour of the following day. The volume was absolutely extraordinary. On February 25, GME traded 4 times the company’s total float. Over three days (Feb 24-26), GME traded almost 10 times its public float. This is probably a record for the turnover of shares relative to the float for a substantial public company.

Volume of GME Shares Traded Feb 22-26 Chart by author

The short squeeze is evidently over. The short interest had declined by February – reasonably so, since the shorts were overpowered by the January surge, and had to close out their positions.

“Short interest in the stock has substantially diminished. As of Feb. 12, short interest in GameStop stood at roughly 30% of the stock’s free float, representing the lowest short interest in the company since the end of December 2018.”

So the new surge looks more like a pure “gamma” event, which from an analytical standpoint is more revealing.

The options activity is now clearly the focus of the event. In the January swarm, too, call options trading soared — this is the “gamma” signature.

“GME jumped 92% yesterday [Jan 28] as call option volume went through the roof. The r/wallstreetbets Reddit crowd have really ramped this stock through aggressive call option buying which is putting huge amounts of pressure on other market participants. To put the action into perspective, GME stock option traders exchanged nearly 1.5 million call option contracts yesterday and only 178,000 put options.”

But most observers focused on the slaughter of the short sellers, rather than the options activity.

In February, however, with the shorts depleted (relatively), options volumes exploded again.

Volume of GME Call Options Feb 22-26 Chart by author

In a little over an hour on Wednesday, February 24, the orchestrators of the gamma surge effectively gained control of the stock and started to drive it upwards. The volume of call options exponentiated — from 63 contracts at 2:25 to over 8000 contracts at 3:46 when trading was halted for the second time in 10 minutes. The pile-on continued on Thursday, as the rout was now clear. Trading was stopped four more times in the first half hour after the opening on Feb 25. As in January, the balance was skewed in favor of Call options.

GME Call Option Volume Feb 24 Afternoon Chart by author

GME Share Volume 12-4 Feb 24 Afternoon Chart by author

The share price went on a rip, which must have stunned a lot of the market know-it-alls. A second surge like this is not supposed to happen. (It certainly took me aback. I thought at first that the person who gave me the news had to be joking.)

GameStop Share Price Feb 24 Afternoon Chart by author

The options “gasoline” stoked the fire. Trading was halted, but the run-up continued after hours and even more furiously the following morning.

The options volume was not a smooth flow. The “ignition” phase seems to have been between 2:30 and 3:30 pm on the 24th. Call options suddenly began crashing into the market in a series of pulses. Call option volumes reached levels nearly a hundred times larger than just two hours earlier. If we examine the crucial window, the pulses are clearly visible.

Surges in Volume of GME Call Options 230-330 Chart by author

The share trading volumes mirrored this pattern, with a lag.

Surges in Volume of GME Shares 230-330 Chart by author

If we superimpose these patterns, it becomes clear that the options trades are driving the share trades. The following chart is somewhat busy, but the message is clear: the pulses in options volume precede the pulses in the trading of the shares by 1-5 minutes.

Surges in Call Option Volumes Followed by Surges in Share Volumes - Detail 2:30-3:05 Chart by author

The raw correlation between the volume of options and the volume of shares in the course of the afternoon was about 68%. The correlation of volume with price was 88%. Drive the options, drive the share volume. Drive the volume, drive the price.

1. The Gamma Squeeze Is Real

The pattern conforms to the “gamma squeeze” concept – where the surge in options is followed by a surge in share volume. Correlation, and Precedence of A before B, are two criteria for establishing causality. It appears that the options trades are driving the share trades. It accords with the idea that options sellers are quickly hedging their positions by buying shares. This would certainly be prudent in a rising market, where the risk of selling a naked call option (without hedging by buying the shares) increases with the share price, as illustrated in this example based on Tesla options (from my previous column).

Naked Call vs Covered Call Chart by author

2. The Gamma Squeeze is Not Dependent on the Short Interest

The extremely unbalanced short position that contributed to the January eruption was no longer in place in February.

GME Short Interest Early 2021 Chart by author

The second surge shows that a Gamma Squeeze can be effective even with a much-reduced short interest. “Gamma” looks like an independent phenomenon.

3. These Episodes Will Become More Frequent

So far the Reddit swarm seems focused on replicating the GME template, with companies that have large short positions. But this new surge suggests that other companies with different shareholding profiles could be vulnerable. Factors such as size or liquidity could be important. We probably don't know yet what the risk factors are.

I admit that when “GameStonk 1” erupted, I was skeptical about any larger significance. It seemed like a one-off, a special situation.

I have come to see that there is enormous leverage inherent in two new factors, which are interrelated:

the use of call options to drive quasi-forced buying – the “Gamma” formula means that each dollar spent on buying an option can under the right circumstances drive 10 or 20 or 50 dollars of share purchases through the hedging operations of the option-sellers

the “swarm” factor – the old market networks operated (legally or otherwise) with perhaps a few dozens of participants; the Reddit’s r/wallstreetbets is said to have 9.4 million members. If even a fraction of them coordinate their efforts, they can overrun the market

This leverage has changed the game. It will be “interesting” to watch as traders probe the market with this new instrument, to find out what it can really do. I’m not sure they even know yet what power they have.

[I have not tried to formally quantify this leverage. But consider an example – with data that is time-stamped at the close of the market on Tuesday, March 9. Imagine that a swarm of, say, 10,000 members, each invested $1,000 in GME $270 call options for Friday March 12. The March 9 cost of the option is $24. If all option sellers hedged, it could drive perhaps $100 million of share volume, at the then current prices.

Would they hedge? GME closed March 9 at $246. It was up $118 in the previous 3 days. If it ran another $100 in the following 3 days, each option seller would lose $52 on each option. I suspect they would consider hedging.

Update: GME traded above $300 on Wed March 10 – spiking as high as $348. A naked March 12 call option with a strike price of $270 would have exposed the seller to a loss of $56 a share. It is highly unlikely that the sellers of such options would have allowed themselves to be exposed to this risk. They would have covered, hedged, by purchasing shares – adding to the surge. Gamma power!]

Leverage – in the physical world – can be used to break things, to pry them loose. Like with a crowbar. Gamma leverage is a powerful new strategy to commandeer the share price, to pry it loose from fundamental value.

It is part of a bigger picture, a sea-change in the character of the markets. The long-simmering processes of detaching investment decisions from traditional price and value concepts – fostered by passive index-tracking and high frequency trading, among other trends – had looked like a slow, anesthetic drift away from rational pricing. With the “Gamma swarms” the process has suddenly become violent. The “Gamestonk” rout accomplished in three hours what it took the engineers of the legendary Volkwagen short squeeze three long years to execute. And now the swarm has shown they can do it again, even without the short squeeze.

Many things are swept away in this storm – rational price discovery, market efficiency, supply-demand equilibrium… We’ll have to get used to a new sort of market regime.

Crowbars are so old-school. The “apes” (as they call themselves) have chain-saws now. Watch out.