Our writers Cansu and Emma conducted an interview with Bocconi Finance professor Massimo Guidolin about the recent GameStop fever.
Here is a quick and simple recap of the events for those who couldn’t follow the news or those who would like to refresh their memory: certain hedge funds had been “betting against” GameStop Corp. by excessive short selling when a group of Redditors collaborated to simultaneously invest in GameStop in January 2021. The aim was to make use of the risky and vulnerable position of the short-sellers and hence to make money. The strategy worked. In fact, owing to bigger investors seeing the opportunity and growing attention from social media, the stock price for GameStop skyrocketed over a short period of time.
These remarkable movements in price motivated us fellow writers of Tra i Leoni to conduct an interview with Professor Massimo Guidolin to learn more about the dynamics of this incident. Prof. Guidolin is a professor of Finance at Bocconi University. He obtained his Bachelor’s degree in Economics at Bocconi and completed his Ph.D. in Economics at University of California, San Diego. His research interests are non-linear time series models in finance and macroeconomics, forecasting, applied dynamic portfolio choice, empirical option pricing, and asset pricing models with learning and belief dynamics.
Over the last month, there were substantial decreases in the price of the share, yet on February 24 the price resurged: at one point it was up 100% from the previous day. This time the move included similar stocks such as those of the cinema chain AMC, fashion retailer Express, and software company BlackBerry. Professor Guidolin stated that the moves are fueled by highly speculative trades arising in the options markets, similar to the previous episodes.
Emma Velasquez Mariucci: The first question we wanted to ask you is, how does the Reddit/ GameStop fever compare to previous events like the dot-com boom and bust or the housing/banking crisis of 2008?
Massimo Guidolin: The dot com boom and bust and the housing/banking crisis were bubbles and took a few years to form. The beginning of a bubble is difficult to date, but, for instance, the dot-com one occurred in the 1997-2000 frame, so it took almost three years.
The Game Stop incident, on the other hand, happened in less than 40 days and, rather than a bubble, which is a psychological phenomenon, is a pump and dump. You may call it “a bubble that you’re aware of creating”. In a pump and dump, you take something which is oversold, and you count on the fact that the short-sellers can lose infinity. At some point, the investors pump everything, meaning that they close all their short positions. So, the parties that were inducted into the dump and pump become incredibly rich.
Cansu Süt: Given that on the Internet you can mostly find superficial information about this incident, can we talk about the technical aspects?
Massimo Guidolin: There are two stages that come together more and more in modern times.
First, there is a short squeeze, which can exist with or without derivatives markets. People coordinate to buy something that is being oversold in short to cause trouble to the sellers, as they eventually must buy back and cover their position. They make money, because their buying pushes the price up, and, because those who sold short are eventually forced to buy, the price increases even more.
The second stage, the gamma squeeze, can happen when the derivatives market is associated with the stock market of the futures. It concerns the devotees and is encouraged by the fact that market makers have to and want to hedge their positions. If they send you a long position, they are short and they need to cover, namely to buy stocks, in such a way that their books are kind of balanced. They hedge but do not cover the risk entirely, so there is a little risk taken in the books. But when the price of the stock starts going up, the market makers have to follow the direction of the price. So if the stock price goes up, they have to buy stocks. If the stock price goes down, they have to sell stocks to keep their books hedged, so they help a lot of the movement in the price.
When you have a short squeeze plus the gamma squeeze, it’s dramatic: the price can double every half a day. That’s what happened, basically with Gamestop.
Cansu Süt: The mystery of the phenomenon is its scale.
Massimo Guidolin: Indeed, the scale and the magnitude of it were above expectations. The people who created it knew more or less what they were doing. However, it got out of hand and people made much more money than they initially imagined.
Also, it happened through Reddit, and they targeted other people with political intent. Moreover, by chance, there were people supporting it, like Elon Musk and Mark Cuban. There was a lot of glam around it, it got press coverage. It was a good story and making it a good story encouraged people to pile up even more.
Cansu Süt: How difficult is it for people to create such a large-scale effect?
Massimo Guidolin: To do this, you need to convince a group of people with some non-negligible amount of money to all perform the same type of operations simultaneously in the options market.
In the options market, even little money with leverage can move a lot of positions and force a lot of hedging. If the options market remains working the way it works in the US, which is likely, then it is not so difficult to do. Again, going from 20 to 40 is one thing, going from 20 to 480 is another. It would not happen very often, it’s just by chance.
Cansu Sut: Do you think this was orchestrated by a group of capital owners, as some people claim?
I don’t think it was originally orchestrated. The starters probably were a group of people like us, around 30 of them. Each of them investing ten thousand dollars is enough to start something on which the hedge funds jump. At that point, the hedge funds make millions, but also those 30 people make millions.
Emma Velasquez Mariucci: On January 28, 2021, Robinhood, Interactive Brokers, and Webull shut down the buying feature of GameStop and other stocks. The move was frowned upon by politicians and caused a wave of anger towards Wall Street for supposedly rigging the system against individual retail investors. Could you please share your opinion on this?
Massimo Guidolin: There are institutions in the financial market that are making money in ways that are not well understood. For instance, Robinhood makes money from selling order flow. They essentially direct the flow of the trades of their customers through intermediaries who are paying them for that. They are paying because the order flow reveals information, making stocks predictable for a few seconds or minutes at most. But if you have automated trading, a few seconds can actually be a lot of pennies, which sum up to millions in one year.
During a pump and dump, there is no information: the price is off and there is no way to profit from knowing the order flow when the price is off. Thus, the buyers of that info are no longer ready to pay, and they press Robinhood not to sell them an order flow that contains no information. Then Robinhood has no incentive to keep providing a seemingly free service, which is not generating any profit for Robinhood and the customers of Robinhood.
I believe that the political process should force companies that offer products for free to clarify whether they are philanthropic, namely whether they provide for you for free because they like you, or whether they are making money in ways that are hidden. And if the latter is the case, then that should be explained. The Social Dilemma, the show everybody’s watching on Netflix, is about that.
Cansu Süt: This is indeed an important thing to keep in mind.
Massimo Guidolin: Now, the other thing that is a bit unfair is that politicians hear the complaints of people trading in the stock market, and Robinhood is about the stock market apparently; they suspended the stock market trading.
So it looks like it’s about being able to buy and sell stocks. That’s not the problem. Without the options market, there would be no pump and dump. One must reflect on the company as well. GameStop has its employees, people with families who have to serve dinner on the table every night: it is not worth zero.
Cansu Süt: There must be some other companies hurt in this way, but we only know of GameStop because of the media coverage, isn’t it?
Massimo Guidolin: In fact, there is a group of companies whose names came up. One, for example, is AMC. That’s a bit different because movie theaters make losses for real for the moment, so maybe the value of the company is really close to zero. However, AMC depends on Covid-19: if Covid goes away and life goes back to normal, if we are all vaccinated, then the movies will reopen, and AMC will again have a lot of value. There are a few companies in this situation regardless of Covid, Nokia and Blackberry for instance.
Cansu Süt: Do you think this incident will generate more regulation in financial markets, because it got out of hand and some politicians or central banks were not “happy”?
Massimo Guidolin: The main problem is the model through which retail broker firms like Robinhood are paid. I don’t know how it will be possible to forbid firms to be paid to sell trading flow, maybe a regulation about the connections between the different types of financial intermediaries.
The cure for many of these problems is information. People must understand that you cannot just pick a stock and make the price go up and everybody becomes rich. Option contracts expire, so the mechanism works until the options are in line.
A way to curb the phenomenon is to financially punish people who are not delivering. Then, short-sellers will be much more careful about overdoing it because they will be running the risk of paying an additional tax. That is doable and it will generate some revenue for the government.
Cansu Süt: I see a parallel between this incident and the subprime mortgage crisis: back then, they were integrating subprime derivatives into other derivatives, but there is no way to technically stop this because you can sell an asset that was lent to you to somebody else, and you can do the same thing with derivatives. You can package them and sell them to other people. I think there is no way to stop this other than outright banning it, which will not work.
Massimo Guidolin: I think the origin of the subprime mortgage crisis is political because the US government made, for 15 years, a big effort to allow everybody to buy a house. So, they started lending money to people who did not deserve it. The subprime market is the reaction of the financial system to the pressure to lend money to people who should be not borrowing money.
So what do you do? Yes, I give you the money, but one minute later I will try to give it to somebody else and they will try to give it to somebody else. And this is passed around until it gets fragmented to be in such a way that it’s no longer recognizable. But at the end of the day, when the recession comes, interest rates go up and they’re not able to pay.
Here we’re talking about simple options. Only those derivatives exist in GameStop. I think nothing went wrong in this case, actually, it went just very right. If you abuse selling short, you need to be punished. Melvin and Citron wanted to have thousands of people lose their job. Then they lost money and they were punished. So next time they will be more careful before actually pushing companies to extinction by betting on bankruptcy. It gives a very good message, in fact.
Emma Velasquez Mariucci: It’s easy to see the overall mania for day trading today—propelled by a combination of social media, easy-to-use apps like Robinhood, and Covid-induced boredom. How do you think this has changed the perception of trading? Do you think it has led to a paradigm where small investors are “smarter” than Wall Street?
Massimo Guidolin: We don’t know if the “little people” got smarter than Wall Street, because here there is the impression that they were used by some hedge funds against other hedge funds.
The phenomenon we are observing is called “the gamification of finance”. Many activities that were taken very seriously up until a few years ago seem now to be taken very lightly, and this is just one example of that. I take a short position and I allow other people to take short positions on top of my short position. That’s the way it goes. They’re not taking very seriously the possibility for GameStop to actually resurrect.
And as a result of that, another “game” begins: people find themselves in a WhatsApp group and think “let’s take a stock and push the price up ten times, and let’s see what happens”. “Let’s see if somebody goes bankrupt on Wall Street.” The Game Stop event is just the tip of the iceberg. You can see the problem everywhere.
Part of the problem is being at home and getting used to seeing people on a screen. After a while, you lose track of reality.
Emma Velasquez Mariucci: Do you feel this is a side effect of “democratizing” trading?
Massimo Guidolin: It depends on what “democratizing” means. It was possible to buy and sell stocks also 20 years ago too, but it was more difficult and it didn’t look like a game.
Now, if you make trading platforms free, if you make them very colorful and make it possible to use them through the phone, it looks like playing a video game. That is going to cause confusion.
Cansu Süt: So, you consider this more of a sociological phenomenon?
Massimo Guidolin: Entirely. There are problems in our society. Some of them are justifiable, for example, Covid-19 is not our choice. We have no control over what is happening. On the other hand, there is a technical aspect, which is the way the derivatives markets work. And these two things can clash together and they will originate from this.
Cansu Süt: In most of the previous crises we experienced a stock market crash. Nevertheless, despite the huge crisis Covid-19 created in the real economy, the stock market has been booming. How can we explain that?
Massimo Guidolin: In general, markets react before things happen. If you look at the Covid-19 data and the stock market behavior, it’s quite visible that markets react a few weeks in advance compared to the data.
Part of it is because prices incorporate expectations between now and infinity. So, little changes in expectations compound and they can move prices a lot today. Part of it is that there are firms in the stock market that invest in research, so that they know about trends in the spread of contagion that we don’t see yet. Part of it is gamification: some people, as Emma was saying, really got bored at home and start playing games in the stock market, by buying and selling stocks.
Cansu Süt: So, do we expect things to get better but over a long period of time?
Massimo Guidolin: Things are adjusting at a slow pace, and maybe it is true that in many countries things will get considerably better in a year or so. On the other hand, if you think things will not go well anytime soon, and, if it’s justifiable, then you can sell a lot of your stocks. And this will cause prices to move a lot. If you look at prices, we are back to where we were in February 2020. Back then, people were already thinking that maybe prices were a bit too high, but we were not talking about a bubble.