Gamestop (GME), shorting, dynamic hedging, options…

…in other words, random-ish thoughts.

how shorts play out

I was recently reading an analysis of GME by Aswath Damodaran, a finance professor at NYU’s business school, who seems to me to be unusually insightful for an academic. In a recent blog post, he comments that history shows that successful shorts typically run out of steam when the stock being shorted has lost 90% -95% of its value. Not only that, the stock subsequently bounces sharply up. His question: why hadn’t Melvin Capital, the primary target/loser in the recent GME short squeeze run the risk of bankruptcy by not closing a lucrative short bet once it passed its best-by date? One possible answer: Melvin had no idea.

OTC derivatives

Others have pointed out that Melvin should have been shorting through what are called OTC derivatives. These are private contracts between a broker and an institutional client that get the client the effect, for good or ill, of ownership of a financial instrument without actually owning it. That way there would be no public record of Melvin’s shorting.

An example: at one point in my working career I wanted to invest in India. That required registration as a foreign institutional investor with that country’s securities authority. After waiting six months in vain for my legal department to get through what was normally a two-week process, I decided to enter an OTC contract with a broker. I deposited an agreed-upon amount of money with the broker, based on the number of shares of company X that I wanted to buy. My fund would be paid the gains from owning my target stock–and would pay the broker for any losses. The contract would be settled and renewed at the end of each month. (For a publicly traded mutual fund, though, the contract was a pain in the neck to price every day. The charges for the contract weren’t clear, which bothered me. Also, I found I wasn’t becoming mentally linked to the ebbs and flows of Indian stocks in the way I would have been had I owned the actual shares. So I ended the contract after a month or two.)

About Melvin and GME, yes, using OTC derivatives would mean Melvin’s identity would not have been revealed. But that doesn’t mean that there would have been no public record of its shorting. I’m sure that if I weren’t mostly trying to prod my lawyers into action (without success, as it turns out) I would have dug deeply enough to discover this bespoke service was very expensive. Another drawback–the broker would likely be able to end the contract on very short notice.

From another angle, though, Melvin may have wanted its activity to be very visible, in the hope of attracting momentum players into joining its attack. And, of course, for all we know Melvin may have had a whole bunch of OTC derivative contracts involving GME–and betting either for or against the stock–as well

Then there’s dynamic hedging.

dynamic hedging

This is a common statistical technique developed in the academic world and first put into practice in the US stock market in the fall of 1987 (think Black Monday). It works like this:

I establish an OTC contract that gives me the effect of shorting 1,000,000 shares of GME. The broker on the other side of the contract is at least notionally long a million shares. It probably doesn’t want that much exposure. So it goes into the market to hedge its own exposure and shorts, say, 500,000 shares, as quickly as it can without depressing the price (an aside: that 500,000 share short appears in the public record). The broker also has a program that trades around its exposure, shorting more if the stock begins to rise and reducing part of the short position if the stock begins to sag.

In the perfect world for him, the broker will make steady money by trading around the position and my using the funds on deposit. But if the stock starts to move down, the broker will increase its hedge by shorting more …and likely more aggressively. If the stock begins to move up, the broker will cover …and likely more aggressively here as well. In other words, the existence of OTC contracts adds to potential market instability in any stock. It will increase the strength of both upside and downside moves in the stock once it gets going, until it completely de-risks its position..

options play a role, too

This is a lot like OTC derivatives, only these are standardized and publicly-traded–meaning they are cookie-cutter form as regards contract size, strike price and expiration date. For this post, the important common element is that market makers who take the other side of a retail investor contract is that they too use dynamic hedging. So they too may initially hedge only a portion of the obligation to deliver stock to you if you buy a call from them. And their activity can accelerate the rise in price of the underlying stock. As the number of call options in a given name a market maker sells, the hedge ratio for his entire short position begins to rise.

Because of all this, even a small push and quickly snowball.

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