Game Shop, Game over?
In the past weeks I had not paid attention to the stock market, much less to Game Stop stock (GME), but a call from a friend got my attention. We like to talk about the stock market, and he asked me about my opinion about this stock and the phenomenon that was taking place in the market. At first, I thought it was just another “hot stock” among millennials like GPRO (which rose to almost $90,and today is trading at less than $9), victim of the phenomenon known as “pump and dump” of artificially inflating the price of the stock.
But no, as I reviewed the news, I realized that the GME case was much more interesting, and it could open the door to different scenarios that had not been seen in the markets.
After reading the articles published, the story is basically the following:
First, through a site called reddit, registered members submit content to the site such as links, text posts, and images, a subgroup called “wallstreetbets” was created, where apparently thousands of users coordinated to buy and promote the purchase of the GME stock, in which several investment funds such as Melvin Capital, had a huge “short position” (sold stocks the fund didn’t have).
According to CNBC, the fund closed out its Game Stop short position on Tuesday afternoon (January 26th), after taking a huge loss. So apparently a lot of retail traders mainly millennian’s using trading apps like “Robinhood” bought in a couple of weeks millions of shares of GME generating a huge “SHORT SQUEEZE” (A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to forestall even greater losses).
There have been a lot of Short squeeze in the past, but GME is different because “apparently” it has been created not by a couple of “big pockets” investments firms, “market makers” or “Big players”, no, it was created in a kind of “David vs Goliath” story, with hundreds of thousands of retail investors against some big funds.
Some of us can think that we finally see the “revenge” of individual investor against “institutional traders”, that usually get the news before and “always wins”, as you can expect this was my first reaction, but wait… , can you predict what is going to happened next?
That led me to think about what could happen in the coming weeks.
According to Robinhood (free trading app), during the past year its user base grew by more than 3 million, reaching a total of 13 million. These users are mainly millennian’s of 31 years in, and according to JMP Securities, the average account size for a typical Robinhood account ranges from $ 1,000 to $ 5,000.
During the past year, the Covid effect put people into their homes and laptops, in “home office mode”, that allowed them to have more time and “put some money to work”, trading stocks on the internet , and apps like Robinhood made it possible to easy create an account with a minimum deposits. Also, the Financial Industry Regulatory Authority (FINRA) mandates that investors deposit at least $2,000 into their accounts before been able to trade on margin.
So let’s think: the past year millions of retail investors took some of their savings and open an account in Robinhood and other low cost brokerages , we can assume that the vast majority were millennian’s , who surely have no experience in stocks and have never invested directly . This small accounts have access to “play” and “speculate” with stocks and crypto currencies. (it’s no coincidence that cryptocurrencies are all time high).
These typical investors, also have access to “margin” (so if they have a $ 5,000 they can trade up to $ 10,000),
According to Yahoo finance, on January 12 , Game Stop (GME) opened near $19.96 and reached $20.40 per stock with a volume of 7 million shares exchanged in the day, a normal number for the stock. However the next day the stock opened at $ 20.42 and reached $ 38.65 with a volume traded of 144 million shares representing a twenty times increase in volume (big demand for the stock).
Let us think of those investors who bought on January 13 and got an average price of $ 30.00, they were not one who bought it “cheap”, nor the most expensive at $ 38.65.
In round numbers, these investors saw the value of their “investment” multiply by 10 times after just thirteen days on January 27, GME closed above $ 347, having an intraday maximum of $ 380.
Assuming that the value of their account was $ 5,000 and they had decided to invest $ 3,000 in buying 100 shares of GME at $ 30, this would imply only 30% of the value of their purchasing capacity including $5,000 on margin, they do not even invest all their capital in a stock, they realize that GME was a “lottery ticket” and they bought it just by following an advice or recommendation from reddit users to see what happened.
This “investor” account reflected on January 27 after the market close, a net worth of $ 36,700 (GME closing price $347 times 100 shares, plus the rest $ 2,000 cash not invested in the account). So if my math is correct, a $ 36,700 account can purchase up to $ 73,400 just in stocks (not to mention option trading with 10 times leverage), using the 2x1 margin authorized by the FINRA. This represents almost 15 times the purchasing power from the original $ 5,000 funded into the account.
So, following this line of thought, that investor who was “cautious” who only invested 30% of his purchase power, and who followed some advice to buy GME, realizes that “he is a genius” in just thirteen days he multiplied the value of his account by 7 and he has a “credit” to buy $ 73,000 worth of assts.
Now he realizes that he has been very lucky and that now is the time not to keep speculating and decides to buy “solid” and well capitalized stocks, so he looks at his “watch list” (full of stocks that millennians follow) and decides to “diversify” (with what he understands as diversification, which is just buying several shares so as not to have “all your eggs in the same basket”), and decide to buy shares of AAPL, FB, GOOGL, AMZAN, TSLA, TWTR, MSFT etc. And he invests all the potential that the Robinhood allows him, more than $ 73,000 in those stocks.
So far so good, right? Then I started to worry, with what I saw Thursday and Friday with the market. Robinhood decided to limit the purchase of GME stocks along with other 50 assets, GME Short squeeze was the main headline of the day, and then everybody started to ask what will happen next, when does the “pump and dump” will stop?
So, lets imagine in the coming weeks that GME stock price drops, and the hundreds of thousands or even millions of retail investors try to close their positions at the same time.
Those who couldn`t close it and following the past example of our “hypothetical investor”, with 100 GME share on the portfolio, with a sudden drop to $30, will see that the portfolio will shrink again to their original $ 5,000.
But wait… they already own more than $ 70,000 in “solid” and “well capitalized stocks”. This investor and thousands of others will receive MARGIN CALLS. To cover at least $30,000 to be able to keep their holdings bought with margin, and “paper profit” from the GME “sky rocket” price increase.
Looking at the ROBINHOOD FINANCIAL AND ROBINHOOD SECURITIES MARGIN DISCLOSURE STATEMENT you can read the fine print:
WE CAN SELL YOUR SECURITIES OR OTHER ASSETS WITHOUT CONTACTING YOU. Some investors mistakenly believe that their brokerage firm must contact them for a margin call to be valid, and that their firm cannot liquidate securities or other assets in their accounts to meet the call unless the firm has contacted them first. This is not the case. Although we may attempt to notify you of margin calls, we are not required to do so.
That was my, my “aha ! Moment” , and the “Houston we have a problem…” thinking came to my mind, looking at this possible scenario with huge margin calls happening at the same time. I can imagine a correction in the market in the near future, not just GME but all milenians favorite stocks that will be forced to sell when they can’t fill the coming margin calls.
I hope I’m wrong and somehow this never happen, but these were some of the thoughts I had after the call with my old friend that encouraged me to write this article.
Take care and trade safe.
Disclosure: I do not offer an investment advisory service, nor a registered investment advisor and does not purport to tell or suggest which commodities, securities or currencies. This article is only for educational purposes.
References:
https://www.fool.com/investing/2020/06/22/robinhood-is-not-moving-the-entire-stock-market.aspx
https://robinhood.com/us/en/support/articles/margin-overview/
https://www.cnbc.com/2021/01/27/hedge-fund-targeted-by-reddit-board-melvin-capital-closed-out-of-gamestop-short-position-tuesday.html
