r/WallStreetBets. GME. AMC. Citadel. Ken Griffin. Steve Cohen. Melvin. Matt Levine.
Wait, Matt Levine?
Yes, Matt Levine. Just read everything he wrote this week for staging this entire topic.
My work here is done.
…Ughh fine. I’ll address a few subtexts.
The simplest observation from the hedge fund Melvin’s plight is their bet size was too large. They underestimated both volatility and liquidity. These are not uncommon mistakes.
Morgan Housel explains by analogy:
Forecasting when a species might go extinct is hard because whatever is causing a species to die off rarely progresses at the same rate. It can speed up in the blink of an eye in ways that surprise people.
Say an elephant is being hunted for its tusk. The rate of hunting often massively speeds up over time, cascading into a frenzy that pushes a mildly at-risk species into quick extinction.
It’s simple: As the number of elephants declines, tusks become rare. Rarity pushes prices up. High prices make hunters excited about how much money they can make if they find an elephant. So they work overtime. Then fewer elephants remain, tusk prices rise even more, more hunters catch on, they work triple-time, on and on until the number of hunters explodes as everyone chases the last herd of elephants whose super-rare tusks are suddenly worth a fortune.
Forecasting models that don’t appreciate how frantic the last-minute hunt can become “give a false sense of security when managing large harvested populations,” the researchers wrote. A species’ endangerment starts slow, then picks up, gets a little faster, then boom … spirals into a disaster seemingly overnight. Supply and demand are intuitive; realizing how quickly supply and demand can go from linear to exponential is not.
Feedback loops – where one event fuels the next – often lead to that kind of bewilderment.
Find a feedback loop and you will find people who underestimate how crazy prices can get. (full post)
A Thought Exercise For Outsourcing Liquidity Risk
A portfolio manager shorting a stock will size a position not just based on price target and conviction but based on the risk relative to bankroll and relative to the liquidity. There are conventional ways to do this. Volume, days-to-cover, variance, 90s nostalgia factor (kidding on that one…worrying about that going forward is like closing the barn door after the horse escaped). While these inputs inform a sizing decision, the bottleneck in the risk management process is not in the sizing. It’s in the remedy when your sizing turns out to be wrong. Eventually it will be. Your plan needs to tolerate that eventuality.
Most plans are to cut risk by buying back some percentage of your shorts. This is like trading with a stop. You are constructing an option since you cover as the stock goes against you and you add as the stock goes in your favor (remember if you short a stock and it falls, to maintain exposure as a percentage of AUM you need to short even more).
The problem with this plan is it is soft optionality. It’s not the same as buying a hard option like a deep ITM put, or buying an OTM call to hedge your short position. Hard options protect you from gap risk. You know, that thing that happens when a stock is halted. Or when the US goes to sleep. Or when a gamma squeeze creates a massive imbalance.
To improve risk management, managers should at least entertain the question: “if I wanted to buy X amount of deep ITM puts instead of shorting shares how much would it cost?”
The answer to that question comes from market-makers who sit in the middle of the marketplace. They hoover up market intel to synthesize a price so you can know exactly how much it costs to express your view with a hard option. Sure, that price embeds a consultation fee in the form of a vig, but at least they are on the hook for mispricing. Not you.
A market maker’s job is to price the spread between soft optionality and hard optionality by gauging the liquidity required to dynamically hedge. Market makers are also in highly competitive, low margin businesses. If you pass on their price for the hard optionality you must ask yourself…”is my assessment of the liquidity/gap risk that much better than theirs OR are their margins excessive?”
At the very least, you can consider this reasoning a sanity check before you size up a big short.
Brokerages are in the Credit Business
The conspiracy theories around Robinhood suspending trading in GME can be cut to shreds with both Occam’s and Hanlon’s razors. RH and any broker for that matter are clearly desperate once they resort to cutting off their customers. The customers are the lifeblood.
Sure Citadel pays RH for order flow, but that relationship is downstream of RH having customers in the first place. Just because RH’s checks come from Citadel, not from the Yolo’ing redditors directly, doesn’t mean Citadel comes before the customers. After all if Citadel didn’t pay RH another market maker would slide right in to that spot. To think the customers come second to Citadel is to confuse accounting for economics. It’s breathtaking to imagine this kind of naivety.
What created a situation so dire that RH had to anger its mob? A good ole’ fashioned credit crunch.
I’ll let Byrne Hobart explain not just the dynamic but why RH had to “explain it poorly”:
A simple model of a stock brokerage is that it’s an almost fully-reserved bank. The brokerage has clients, the clients have positions, and in one sense each position is an asset on the broker’s balance sheet, while the customer’s ownership of that position is a liability. So your broker is a sort of bank, that takes deposits in dollars, but also in shares of IBM, treasury bonds, far-out-of-the-money call options on AMC. Normally, this bank tanks very little risk, but there are a few things that can go wrong: trades take time to settle, which creates a brief liability mismatch. Brokers put up collateral to ensure that, in the event that they go out of business before the trade completes, their customers won’t lose their assets. When trade volume rises, and the volatility of the assets rises, this creates a larger demand for collateral.
This is, day-to-day, a problem brokers are able to manage. Their capitalization needs don’t change that much. But when users are all piling into the same volatile trades, the need for capital rises suddenly. As a result, Robinhood stopped processing trades in GameStop, except trades to unwind existing positions. (As did several other brokerages: Interactive Brokers, WeBull, and Public, for example.)
This story certainly sounds sinister; it matches the appearance of strings getting pulled in order to bail out hedge funds. But the brokers’ actions also look like the actions of any financial intermediary faced with a sudden increase in uncertain obligations. (And there were not stories about brokers like Vanguard and Fidelity, which have fewer day-traders, blocking GameStop trades.) When volatility is high, brokers often act in their own interest. This has happened before: one major short-selling firm was basically shut down mid-crisis because their prime broker raised margin requirements. (The prime broker in question denies much of this.) While it’s rare in the US, brokers can go under because of client losses. FXCM, for example, had many clients who were borrowing the Swiss franc to fund other currency bets. It was a stable currency with low rates, until the Swiss gave up on keeping it stable and allowed it to float; it instantly rose 45%, wiping out many clients many times over and forcing FXCM to get rescued by a larger financial institution, and to rescue many of those clients in turn.
Which doesn’t excuse Robinhood, WeBull and the rest. They communicated inaccurately, but not poorly, because an accurate description of the problem was “We’re more of a bank than we realized, and we’re in danger of insolvency.” And that would lead to a run on the bank—and definite insolvency. WeBull’s CEO did clarify this later on, and with enough time to digest it, and new funding from their venture backers, the bank-run risk is minimal.
The brokerage experienced a familiar technology problem — a rapid increase in capital requirements for scaling infrastructure when user growth explodes compounded by a frumpy problem as old as time — the need to raise more collateral.
The combination of these forces should be more than enough to satisfy the explanation with the least and most likely assumptions. If this theory is still not as compelling as blaming Citadel let me ask a question — if you were Ken and owned a machine that printed cash would you rather turn the machine off for a few days or would you try to forge the bills you aren’t able to make jeopardizing the entire future of the printing press?
Please. You don’t make foie gras out of the golden goose.
The Big Guy Vs Little Guy Debate
If conspiracy theories weren’t enough, then we get the ambulance chasers.
AOC, Chamath, and the Barstool meatball.
Right on cue and impossibly aligned proving that the arc of moral outrage bends towards grift.
Unable to resist the warm embrace of Twitter hearts and re-tweets, this band showed up to promote the populist WSB underdog David vs hedge fund elite Goliath narrative. Ranjan Roy dispels that framing handily. Not to take anything away from Roy, but anyone with a clue how trading works knows that framing is nonsense.
Suppose there are 15 courses of actions one can take. 5 are illegal, 5 more are unethical. That leaves 5 acceptable actions. It feels like our collective calculus is moving to a rule of “if it’s legal, why not?”
The ethics ozone layer between what’s legal and what we should do is fully depleted. The air is irrevocably polluted. I’m not pointing fingers solely on daytraders who are openly coordinating behavior in ways that stun anyone who has ever sat through securities compliance training. There is a sense that the game is rigged and while I think the specific targets in these trading examples are misdirected, it certainly feels that way in a broader sense. Especially when we consider the runaway examples of inequality I’ve discussed recently.
My full thoughts on this are out of scope here, but I couldn’t help but chime in on this @skelecap & @SuperMugatu thread.
Sticking It To The 1%
The most populist development in the story is not daytraders getting rich. Sure, a few will, but when you turn GME into one of the top 10% of stocks by market cap you are also guaranteeing a large cohort of bagholders. Since, ya know, math.
The real damage will be to savers in a story that will rhyme with this: