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Risk Anatomy™
A bloodbath, yesterday.
GameStop Stop.png

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I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market Reddit. You can intimidate everybody.

—James Carville, 1993 (updated by the JC, 2021)

Herculio: How now, Ser Jez: how fares thy short?
Ser Jaramey: Squeezèd.
Unwarily I trod the basest range
And sold there what I borrowed:
A common stock of dismal prospect.
Herculio: A manful punt for so scant a likely gain?
Ser Jaramey: Aye but, I thought, yet safe enough —
That laggard scrip, housed around in bricks and mortar,
Whose hawkery of pre-loved flickish playthings
Casts surer shade across the purgatorial chapter
Than e’er it might upon some distant hea’enly host.
Forsooth, the surest thing was up: its only way was down.
Herculio: Oh? Did it not turn out so?
Ser Jaramey: A noisome band of amateurs did twist its price.
That vapid instrument prescribed a path most inopportune.
Herculio: A sideways move perchance?
Ser Jaramey: How might I wish!
Nuncle: It went to the moon.

Otto Büchstein, Ser Jaramey Slizzard

In which the experts in the market got properly schooled by a bunch of daytraders. Acres have been spilt on this elsewhere, but the JC’s own hot takes are these:

First: everyone knows shorting gives you unlimited upside risk. But there is still this basic supposition that, okay, it’s theoretically unlimited, but practically? — c’mon. There are rational bounds to which no stock can go. Well, we now know this not to be quite so obviously the case. The internet can stay irrational a lot longer than you can stay solvent.

Second: Shorting a stock that is at the bottom of its range is riskier than shorting one that is at the top. GameStop traded at $4 in July last year. Almost a dead duck — business model fundamentally in the toilet. It looked like things could only go one way — the way of all flesh, and high-street retailers — but they didn’t have to go too far the other way to make a mess of your pretty hedge-fund face. This would have been different were the stock higher in its range. If the cash you have available for margin is limited — it is; see below — and you put on a $5,000,000 short at different prices, the potential downside payoffs are wildly different. Say you have a billion dollars cash on hand (hey — you’re a hedge fund. This is chicken feed).

Buy Quantity Peak Margin Implied Bust Price
$3.69 1,355,014 $469.00 $631,070,461 $701.10
$36.90 135,501 $469.00 $58,607,046 $7,011.00
$369.00 13,550 $469.00 $1,360,705 $70,110.00

We have also estimated the point at which a billion-dollar fund (fully into cash!) would run out of cash to post margin (this is the implied bust price). The closer it is to the bottom — zero — when you short it, the more shares you can buy with the same money, and the more amplified is the effect should the shares tick up. Can we imagine GameStop going to 700? Super unlikely — but not out of the question. Can we imagine $7,000 though, or $70,000? What would Homey say about that?

Third: There is a hard practical limit to how far any short investor can let a losing short position ride. This is the ugly side of the limited recourse investment vehicle: you only have so many chips in the casino. While you can continue to fund margin calls, you can keep your position on and ride it out. But only while you have free cash on hand. Of you run out, no-one is going to lend more to you, however convincing your proposition. And raising new capital is the same as crystallising your loss on the position because it dilutes your existing investors into oblivion. The new capital will come in at the existing net asset value per share of the fund — your mark-to-market NAV per share is pretty much zero. Your new investors are going to require a helluva lot of shares. And really, why wouldn’t they just use their money to put on their own short position? As per the table above, that is a much safer bet.

Fourth: Fully-paid long investors — in this case, internet denizens and Redditor day-traders — do not have this natural constraint. They are borrowing to invest; as long as they don’t need the money to pay their rent — which they may well do — they can sit indefinitely.

Fifth: The internet is a beast. It is one thing to hold out short interest against one guy — Bill Ackman’s short on Herbalife versus Carl Icahn is the signature dish of that fight — and there is it a case of who has the bigger pile of chips. But if you are shorting against a meme stock where everyone is blindly, stupidly, piling in because it’s cool to stick it to the man, or because some influencer on Insta told them to — you are fighting an unlimited hoard, ram-raiding the casino with a pretty-much limitless supply of fresh cash. You have a hard limit. The world wide web doesn’t.

Sixth: The Wikipedia effect: don’t write off the Redditors. Reddit has a sophisticated reputation management system, and the best stuff gets filtered to the top. There were 2 million subscribers to that forum before the whole GameStop thing kicked off (there are 6 million as of Jan 29), then the odds are that a significant number of them — you know, thousands — are fully credentialised, regulated, experienced, market specialists. This isn’t just a throng of idiots blindly following gravity. To be sure, much of the following throng might be idiots, but it isn’t idiotic to follow someone who’s smart. Indeed: plenty of folks in the hedge fund industry make a decent living copying other people’s trading strategies too.[1]

Seventh: The regulators are going to want to do something to someone. It’s hard to see how that could be some HODLer on Reddit. Nor the Hedgies: they were just doing the deep-state, Pizzagate stuff all hedge funds do. A few market infrastructure players look to be volunteering to take the rap by strangling long interest amongst the day-traders, while the lucky old deep-state-connected hedgies carried on with unfettered access (barring the short-tick requirement, which meant they couldn’t short on a down-tick). But the sense that the market infrastructure guys were acting out of the same good intentions that pave many a road to hell: some little people will, eventually, get hosed here, and they could say they were intervening to stop that — took on a rather greenish cast when it turned out that the retail platform’s biggest market-maker, and payer of an enormous amount for order flow, was closely associated with one of the significant short positions. Now, there is no allegation of actual dastardly behaviour — these organizations have impermeable Chinese walls, but still — it doesn’t look great.

Eighth: This isn’t just “geeks versus masters of the universe”. It is humans versus algorithms. And the algos are losing. This wasn’t in the playbook. The hedge fund industry has the analytical firepower of a fully operational Death Star. They can set their heat ray on an unsuspecting planet and blow it to smithereens. But they didn’t bank on a little planet full of cuddly, bear-like, tree-dwelling Redditors behaving in an unexpectedly concerted way. Algos can cope with dumb, random, Gaussian behaviour — even the odd tail event. But the retail markets isn’t meant to hit back with co-ordinated, targeted strikes on weak points. This is predatory, fast learning, velociraptor carry-on. The retail market is meant to be a brontosaurus.

See also


  1. As Chamath Palihapitiya wryly notes on CNBC Here.