This past week was one like no other. The chatter across the market and more acutely in social media channels was on what are increasingly being referred to as the ‘Meme stocks’. The stocks most heavily impacted were the likes of GameStop (ticker GME), AMC Entertainment and Blackberry, all which finished the week up multiples of where they began. In this post, we seek to walk through what happened this past week.
The ‘meme stocks’ that were targeted had a high level of short-interest among hedge funds. These were largely old-line companies that were viewed by many to be in secular decline. Investors that decided to go long on these stocks did so by purchasing call options, a means of gaining exposure while limiting any potential loss to the price (premium) paid for the option. When an investor buys a call option, there is a counterparty on the other side, such as an option market maker, who is effectively short the stock and needs to hedge that position. To do this, the market maker purchases shares in the equity market. The amount they purchase is based on how sensitive the price of the option is to the price of the underlying stock. This is called the delta of the option. As the share price moves higher, the option becomes more in the money. As options become more in the money, their deltas will rise. Hence the option market maker needs to buy an increasingly higher number of shares in order to stay adequately hedged.
What compounded volume in the ‘meme stocks’ was that as option market makers were buying more shares as delta’s went higher and more option contracts were purchased, short sellers also began to purchase shares to cover their positions as they got spooked by rocketing prices or were forced to cover their shorts in order to meet margin calls. This added an additional layer of buying power in the market. These price insensitive buyers were purchasing to manage exposures and risk, not because they had a particular fundamental view on the stock. These dynamics, in aggregate, led to the incredible wave of volume and price increases in these stocks.
Going into this week, hedge funds had been running at their highest levels of gross exposure in quite some time, meaning they had more short positions and/or deployed more leverage into their portfolios. This served as fuel to the fire as they needed to look to rebalance exposures in light of a market with much higher risk levels. While the outsized movements were in a small number of stocks, most portfolios didn’t have exposure to these names. However, the overall market became more volatile, as evidenced by Wednesday’s move in the VIX volatility index which spiked to a reading over 37; up over 60% from where it began the week. This had the follow-on effect of forcing some portfolios without ‘meme stocks’ to also de-risk in order to maintain their targeted levels of volatility. While markets finished the week down, the aggregate downside seemed measured given the unusual behavior that transpired.
So how does this play out? Time will tell. Its important to note that what has driven share price movement in ‘meme stocks’ has been a combination of speculative trading and risk management decisions. Events such as what’s occurred this past week in the market do create dislocations where securities are sold for risk management and liquidity purposes, not because they are more or less attractive. These types of trading decisions will give rise to attractive investment opportunities if trends like this past week continue. In the meantime, while there may be disruption in a select number of stocks, there is no long-term impact for a vast preponderance of the market and long-term investment prospects remain intact.