The Gamestop Saga - The Endgame And Long Term Prospects

Summary

• An analysis of Gamestops meteoric rise in value, and worldwide attention.
• For the average investor, this will be an eye-opener on how fragile the markets can be, and how greed and arrogance can be very disruptive.
• We will do a deeper dive into market risk management, and the players involved.
• The endgame could be a fierce battle, but the longer-term dynamics are positive.

One of the biggest stories so far this year in the equity markets has been GameStop (GME). What started out as a small relatively unknown firm with a turnaround plan, has become the entire focus of the markets around the Globe. While we all find the dynamics of this saga entertaining, real issues have been exposed in the USA markets that need to be addressed.

What happened here? How did we get here?

I had not heard of Gamestop until Jan 13th this year, when I saw the news that Gamestop had surged over 60% due to a huge short squeeze. At that point in time, I joined wall street bets - WSB on the Reddit platform to gain more insight into this short squeeze. Gamestop sells video game platforms; accessories, including controllers, gaming headsets, virtual reality great, etc. in its 5500 stores around the world.

My first thoughts about the business model were not positive - an aging old school store-based retailer probably having mounting issues with the COVID pandemic. But after more due diligence on this at the time $30 stock, I changed my mind. I started to realize that this is already a very positive turnaround value story. Add on top of that was the 140% short interest on the stock, a great short squeeze attack plan from some retail investors on WSB, I purchased a small position of 300 shares.

My original research on Gamestop was from the 2nd half of 2020. Here is a small subset of news items I digested from 2020: 

Aug. 31, 2020

Gamestop is up 11% premarket after RC Ventures LLC reported a 9% stake in the gaming retailer. RC Ventures is managed by Ryan Cohen, co-founder and former CEO of e-commerce company Chewy.

Oct. 08, 2020

Gamestop jumps 21% on Microsoft(MSFT) agreement. Investors are bidding up the stock after the announcement of an enterprise and commercial partnership with Microsoft. That announcement arrived with short interest on GameStop at more than 100% of total float.

 Nov. 16th, 2020

Investor Ryan Cohen, who holds a nearly 10% stake in the company through his investment firm RC Ventures, is pushing the company to conduct a strategic review after he says private talks with the board yielded little progress, WSJ reports.

Nov. 30th, 2020

Gamestop hits a 52 week high amid strong consumer interest. Gamestop is a  Cyber Monday breakout stock in the retail sector and now trades at a 52-week high of $19.42. As for the bearish thesis that GameStop is no longer relevant with consumers, Google searches on the retailer are at the highest level of the last five years amid the gaming console refresh cycle. 

Dec. 21, 2020

RC Ventures reports an increased stake of 12.9% stake in GameStop from just under 10%.  RC Ventures says it intends to continue to engage in discussions with GME's board regarding means to drive stockholder value, including through changes to the composition of the board and other corporate governance enhancements. 

Dec. 23, 2020

GameStop is a new addition to the Best Ideas List at Hedgeye as a long trade. If the company can execute a turnaround strategy to make GameStop the leading store and online destination for the gaming community, you could have a stock at $50+," notes analyst Brian McGough. Shares of GameStop carved out a new 2020 high of $22.30 earlier in today's session. 

So I was seeing a really sharp activist investor getting involved with a great track record of turning around old school retailers into a cloud-based online powerhouse. Add on top of that an enterprise agreement with Microsoft,  RC Ventures further increasing their stake, and the underlying consumer trends ramping up in a positive direction.

At the time I bought Gamestop in the $35 price range, I was both comfortable with the valuation on a fundamental basis, but also a short term special opportunity short squeeze play. 

The Short Squeeze of the decade?

This would be hard to argue. Gamestop's share has risen from below $40 to over $300 in about 10 days. Many have already started to compare this with the famous VW short squeeze in 2008. These types of squeezes tend to be short term events.

After more research about how this squeeze occurred, I will admit I was becoming more and more angered by the greed and arrogance of the short-selling hedge funds. Little did I know this was just the tip of the iceberg. 

Gamestop traded in the $20 dollar range during 2017. During 2018-2019 the shorts increased their positions and profited by seeing the stock trade down to about $3 in the summer of 2019. So if you are up that much money with very little more money to be made, one would think you would buy back borrowed shares around $3-4, locking in huge profits for your hedge fund.

They did not close out their short positions - why? At this point, it can't really be greed as there were very few additional profits going from $3 a share to zero. This points more to arrogance, and placing that cherry on top of the financial dessert - shorting a stock all the way to zero - bankruptcy. Bulls make money, bears make money, what happens to Pigs? 

Short selling, short interest %, call options

Short selling is when an investor believes a stock will go down and places a bet on this by borrowing someone else shares, selling them with no time limit on when they have to return said borrowed shares. Then when the shares fall enough, a month later, a year, 5 years later, etc. they buy back the shares at a much lower price(the profit) and return the shares.

To me and others, this is a controversial practice. Elon Musk has a similar opinion of short selling as I do:

u can’t sell houses u don’t own u can’t sell cars u don’t own but u *can* sell stock u don’t own!? this is bs – shorting is a scam legal only for vestigial reasons

I could provide links on this subject but you can all google so I won't. My take on the benefits of short selling:

• Better price discovery
• More volume - better for profits of brokers, market makers
• A throttle so to speak on stocks from going up to fast or too far

So Elon Musk claims these benefits are "vestigial" - that we no longer need Unlimited loss potential, Infinite loss potential, Infinite liability

SA readers: I am not trying to fear monger here - really not. I am just annoyed again at the arrogance of wall street at times. They are soo sure that their computer algo's can manage this above risk? This is the market makers like Citadel and large hedge funds like Melvin Capital Management, and the regulators themselves as well.

Breaking news: 

Melvin Capital lost 53% in January on bad trades like GameStop - WSJ

• The losses came not just from the GME short, but from puts on rallying stocks like Bed Bath & Beyond(BBBY), GSX Techedu(GSX), and National Beverage(FIZZ).
• In a separate article, the Journal highlighted how much market-making business Citadel, which was part of the $2.75B infusions, handled this past week.
• The fund is running $8B, including the $2.75B, down from $12.5B at the start of the year.

So it looks like Melvin lost over half its value in about 10 days. Think about that? One of the most respected Wall Street hedge funds in the market did not have proper risk management?

I firmly believe there is no risk management for positions/practices that have unlimited loss potential - period! Here is a theoretical example of an Interactive Brokers account:

IB account XXXX	Balance Sept 2020	Balance feb 1 GME $400, AMC $20
FAANG holdings	$1,000,000	$950,000
GME short at $10	$0	-$1,000,000
AMC short at $2	$0	-$750,000
Margin	-$100,000	-$100,000
Portfolio Value	$900,000	-$900,000

This above account is fictitious - originally $1M in its long book, 2 shorts, and a $100 K margin balance. Look pretty safe right? But when your short position on Gamestop at $10 - moves against you above $300 in just a few days, IB may not be able to liquidate you fast enough! 

So the question? Who pays for the $900K account shortfall? Well, most probably Interactive would be on the hook here. This could happen to any broker. This is one of the reasons that RobinHood and IB limited folks from buying Gamestop this past week. The other reason was pressure from Citadel in my opinion - we will explain that further along when we discuss the call options markets.

On a side note: blocking or stopping one side of a stock trade is pure and simple market manipulation. These brokers did not stop anyone from selling - just stop folks from buying! This can only lead to forces pushing the share price downward.

Citadel and call options

Citadel Securities acts as a specialist or market maker in more than 3,000 U.S. listed-options names, representing 99% of traded volume³, and ranks as a top liquidity provider on the major U.S. options exchanges. 

When someone buys an Out of The Money(OTM) call option, the "premium" price of that option is determined by maker makers like Citadel. Citadel to start the process - - grease the wheel so to speak, sells you the call option.

Citadel now has a liability on this contract at that strike price - they have to provide you the stock or $$ for the difference in price. So for every call option transaction, Citadel and other MM's hedge this risk by buying some share of the stock, but not all. Given time, Citadel can buy the call from covered call sellers - those who actually have the shares. But with all these new strikes on weekly options, they are having trouble finding these sellers.

This is called the Naked call option:

A naked call is an options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. This strategy is sometimes referred to as an uncovered call or an unhedged short call.

So here is the BIG problem. In effect, this is the exact same risk of shorting a stock - you have unlimited loss potential - unlimited liability. Remember the WSB post from Jeffamazon above - the gameplan. Once Gamestop stock starts to rise, he is telling the 4 million Redditors, and others to buy the near term out of the money(OTM) weekly call options.

So every Friday the weekly options are expiring for Gamestop. So every week for infinity(technically), Citadel is facing unlimited loss potential as the stock rises, all those worthless out of the money calls become deeply in the Money(ITM). So we see a battleground unfold every Wed. and Thur leading up to the options expire on Friday.

So this past Thursday I think Citadel pushed RH and other brokers to not allow any more GME buy orders - because they knew they could not find all those shares with soo many options expiring ITM! Also really disturbing is that RH gets most of its revenue from guess who?:

Robinhood has faced criticism over that piece of its revenue model, which relies on selling customers’ orders to high-frequency trading firms like Citadel Securities

I did a quick model of Citadels losses this past Friday just on Gamestop, but remember Citadel will have the same issues with these other overly shorted stocks. To me, it looks like up to about $1B loss on Friday for Citadel for Gamestop.

The Double whammy of settling these short positions and naked call options

The risk management of the markets is under stress. Individual hedge funds and investors, the Brokers like RH and Interactive, and the actual Market makers like Citadel are seeing these losses pile up - and they know there is no limit to these losses in the future.

These dual unlimited liabilities are already showing up, this past week with the major averages down almost 5%. At every segment of the life cycle of equities, stocks need to be sold to cover these losses from just a handful of smallish stocks that were heavily shorted.

The ENDGAME - and long term prospects

This past week has been soo crazy I needed a few days of no market action for better clarity. I see this endgame playing out over time. We will have a short term focus and a longer-term plan. In the short term, we need to focus on some of these heavily shorted, extremely volatile individual stocks like Gamestop and  AMC Entertainment Holdings(AMC). Longer-term we need to have a difficult discussion on market risk management.

The Gamestop Endgame - immediate action and resolution?

So how can we break out of the gamma short squeeze? There is no easy fix. It will be hard to halt trading in Gamestop since we have weekly options to settle. We can't stop one side of trades since that is market manipulation. We can't force shorts to cover their positions in any quick timeframe since there are not enough physical shares outstanding to do this.

Endgame scenario 1 - Do long-term Gamestop investors have paper hands or diamond hands?

Many of these short sellers still think Gamestop is worth less than $5 a share. The current pricing is much higher. Many investors with diamond hands see over $1,000 per share? The key question to answer is what do the large shareholders think? Fidelity, Vanguard? If some of these larger investors think Gamestop is worth less than $30, we could see a mad dash for the door. We could see prices fall back to earth.

Gamestop could also issue equity soon to raise cash for its turnaround plan and provide more shares for shorts to cover. In this scenario, we would also see prices fall from these squeezed record highs.

Endgame scenario 2 - SEC and federal involvement

In this scenario, I believe the regulators will most likely halt trading for a few days - so the shorts can get to work out a plan to reduce the short interest %. Yes, this would probably be another government bailout of sorts. The market makers could stop initiating new option contracts and focus on settling the existing strikes. Also, no more new short positions would be allowed. At some point, Gamestop could be "pressured" to issue shares at the regulator's agreed-upon price. This process would be longer than option 1 for sure, and very messy. 

Gamestop's longer-term prospects

We discussed above the many positive signs that have occurred over the past few months. A smart activist investor invests, a partnership with Microsoft, strong holiday sales, and a product cycle refresh. I see 2 more very positive signs for Gamestop in 2021.

Free publicity and advertising?

I had never even heard of this stock until a few weeks ago. Now it seems a high % of people worldwide know about this stock and the saga that has occurred. There is a saying about this: There is no such thing as bad publicity.

So OK, I do not have a gaming device or console, and will not be buying one soon. But what if Gamestop moves into the streaming online arena? Could be games, Sci-fi, or fantasy animated stories and movies?

I came across this story to give more flavor to this unbelievable publicity:

Listed his 18-foot GameStop store signs for sale online, $1,500 apiece

The online offers came at Schnabel fast, first from potential South Dakota buyers, then from states far and wide as news of his sale was posted to the Wall Street Bets page on the online forum site Reddit, whose users were largely responsible for the GameStop price surge.

"They said grab this thing and put it in front of the New York Stock Exchange to show that the little guy can outsmart the big guy every once in a while," he said.

On Saturday night, Jan. 30, a buyer from Colorado offered Schnabel $20,000 for the signs.

Maybe Gamestop can make a bunch of signs and sell them for extra free cash flows this year! 

The 2021 COVID effect - a strong dynamic for Gamestop

I just published the first in a series of 5 articles on my top 5 stocks for 2021. The premise for my stock picks involved 2 new dynamics heading into 2021 that did not exist in 2020. One of these dynamics is the end of COVID:

While this dynamic is still a prediction, with 2 vaccines already rolled out, and a 3rd to come out soon, we have reason to believe new COVID cases and hospitalizations will decline thru the year. While COVID may always be with us, we predict it will no longer be in the news as much, and almost all COVID-related restrictions will be lifted.

Also if we look at the timeline from the 1918 Pandemic, we see very similar events in the timeline:

This year-long COVID lockdown or restrictions have been extremely tiring and depressing for most - there will be a huge bounce back this year in my opinion. People will want to fly, travel, visit families, friends, new places. We need to see more than just the insides of our homes.

Malls that have been empty in 2020 will fill back up this summer and fall IMHO. Also people will have more $$ in thier pocket to spend - especially the typical Gamestop customers.

Investor takeaways

As for Gamestop trades at this point in time? I do appreciate those traders who have recently bought the stock and have diamond hands. I have more stone hands - not paper, nor diamond. I am willing to sell at the proper price. For those investors like me, a good play may be to sell covered call options on the 2 weeks out contracts. The premiums for even way OTM calls is impressive.

Should investors or traders look to start new positions? I believe investors should wait a week or two before creating or adding positions. Let this saga play out. I do not know what the price will be in two weeks - could be $500 or $10-20. 

Now for traders, there are many possibilities. Call and put options have huge fat premiums. So another play may be to sell cash protected puts options for income and give you an entry point in a position of Gamestop. I would use low strike prices in the $20-40 range.

A word of advice for any investor or trader - only invest $$ you can totally do without! No rent money, don't take your dad's 401K!, etc. Any position or stock can go to zero. And of course, never short a stock for 2 reasons:

First, you have unlimited loss potential.

Second, I will be watching and waiting. I am The Short Hunter. HA!