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Table of Contents

Introduction

In this blog post, we are going to talk about what has been happening to GameStop (with symbol share GME) and how a group in reddit has been able to push the valuation of GME by more than 1400% (r/wallstreetbets) in the first month of 2021. Moreover, Robinhood, an app that is heavily used by retail investors, decided that they wouldn't allow their users to buy more shares of GME on Thursday (28 Jan.), but that they could close their position. This last event might even be more interesting than what happened to GME price. We will discuss the potential consequences and why an app that has no transaction costs might not be such a good thing afterall. But first, let's discuss why the price of GME grew at such a rate during the last month.

The Short Squeeze

Lots of people considered that the retail traders were doing something that was not that smart and that they should stop for their own sake. However, some other people understood that what they were doing had quite a big level of sophistication. Retail traders saw that several hedge funds bet against GME massively. That's an asymmetric bet, because your profit is limited (the company share price can at minimum reach 0). However, the price of the shares can also grow indefinitely. Instead, the retail traders that took a long position have a potential limited loss. Moreover, there was something unique about this setup: GME was shorted more than 100% of its market capitalization. Therefore, the redditors just asked everyone in wallstreetbets to buy call options with short duration. This had several effects:

  1. The brokers that sold those investment vehicles to retail traders had to protect themselves by buying the shares of the action. More the action rose, more they bought shares of GME. This is called a Gamma Squeeze.

  2. When the shares rose, the hedge funds that were short GME had to cover their positions at a much higher price, therefore pushing the price higher.

Knowing that more than 100% of the stock was shorted is of particular relevance, because it means that if there is limited shares in circulation, the price will almost certainly rise.

One thing that we saw last week that was not under the radar of redditors was the limitation that Robinhood imposed on the buying of GME shares.

Robinhood: the crisis

Robinhood is an application that is very well known among young investors. One of the big advantages of Robinhood is that it is commission-free. They don't charge fees to open an account, to maintain the account and no transfer fees. But, as it is well known now, when it is free you are the product. Indeed, they sell the order flow of their clients to high frequency trading firms that try to make a quick buck out of the tendencies of the market (with spread trading as well).

When Robinhood decided to prevent its clients to take new positions on GME, the price tumbled (quite normal: to whom should you sell if you cannot buy). All of this might end badly for Robinhood. Alexandria Ocasio-Cortez said on Twitter

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Several customers filed a class-action lawsuit against the stock trading app. Such customers are claiming that Robinhood's actions riged the market against its own customers. Redditors even created a new subreddit r/ClassActionRobinhood with already ~40K users in it.

Towards Decentralized Finance ?

All of this situation tells us that it is maybe time to automatize the middlemen. That's exactly the aim of Decentralized Finance (DeFi), which recreates traditional finance systems such as exchanges. A centralized exchange is an intermediary and a custodian where two parties decide to deposit their assets in it for exchange. Such exchanges can be hacked, stop transactions from one party (exactly what happened with Robinhood) or fail completely for an unknown reason. Instead, a decentralized exchange aims to use smart contracts to exchange assets peer-to-peer.

There are several projects that are pursuing this, based on ethereum tokens, such as Uniswap, 0x or Kyber. The liquidity is typically provided algorithmically through an automated market maker. Right now, the volume that can be handled is little, but technologies such as atomic swaps are being studied.

Other very important concepts, such as stablecoins and decentralized identities are very intimately connected with DeFi. We might discuss it in another blog post.

What's gonna happen?

GME is being traded at around 230 dollars, with a market cap. of 17billion dollars (as of today). From a fundamental perspective, such numbers do not make sense for a company that was not really in good shape in the first place (several shops closed during Covid and lots of employees got fired, with losses for the year 2018 and 2019). Retail investors, seing that there is no more momentum will start to sell to get their profits. The question is: who is going to buy? Right now everyone knows that the price has beeen ramped. Therefore, booking profits will be something difficult to do. As such, a rapid crash of the price of GME might be expected in the next week(s).


If you would like to cite the present content, please use:


 @article{fabio2021gamestop,
   title   = "GameStop: A Paradigm Shift In Finance?",
   author  = "Capela, Fabio",
   journal = "capfab.io/blog",
   year    = "2021",
   url     = "https://capfab.io/blog/gamestop-a-paradigm-shift-in-finance"
 }






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