Foreword
This post is for beginners like me. I'm writing this down in my own words as I read about it.
All the investors in the following strategies are fictional, very poor, and have excellent credit.
Yes, the following is investment advice. Sue me.
For simplicity:
- Interest is not compounded;
- Capital gain taxes are not considered;
- Trading commissions are zero.
A. Buy low, sell high
Adam likes the company Fake Enterprises, so he believes its stock, FENT, currently trading at $20, will go up (Adam is bullish on FENT). So he borrows $10,000 at 12% interest and buys 500 FENT shares ($10,000 / $20). Three years later, FENT trades at $56, and Adam decides to sell all his 500 shares, for a total of $28,000 (500 x $56). He then pays off his original loan of $10,000 and is now debt free.
What is his ROI (return on investment)? In the three years he has paid $3,600 ($10,000 x 12% x 3) in interest. His profit is $14,400 ($28,000 - $10,000 - $3,600). That means a ROI of 144% ($14,400 / $10,000) in three years, or 48% / year.
The risk of Adam's strategy is that Fake Enterprises does not perform as expected and FENT starts going down. Let's say after eight months of swearing and loss of sleep, Adam decides to finally sell all his 500 shares at $14, therefore taking a loss of $3,000 ( 500 x ($14 - $20) ). On top of it, he has also paid $800 ($10,000 x 1% x 8) in interest on his loan. Adam's ROI is now -38% ( ($3,000 + $800) / $10,000 ) in eight months, or -57% / year.
In the worst case scenario, FENT goes suddenly bankrupt, say one year later, and the stock goes down to $0. Adam has lost everything, including $1,200 in interest payments. His ROI is -112%. At least this is just a one night nightmare, it cannot get worse than that. Adam can write this loss off and get on with his life, having learnt a valuable lesson.
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B. Sell high, buy low
Barbie is bearish on FENT. She believes Fake Enterprises is badly managed and its stock will go down. Her strategy to make money (called short selling, or shorting) is exactly the same as Adam's, except she swaps "Money" with "Shares". Therefore she borrows 500 shares of FENT at 12% interest and sells them for a total of $10,000 ($20 x 500). Eight months later FENT stock is trading, to Adam's despair, at $14. Barbie buys 714 shares ($10,000 / $14) shares, pays off her original loan of 500 shares and is now debt free.
In the eight months she has paid 40 shares (500 x 1% x 8) in interest. Her profit is 174 shares (714 - 500 - 40). Barbie's ROI is 34.8% (174 / 500) in eight months, or 52% / year.
Before we go to risk evaluation, let's tackle what might seem a glaring problem with Barbie's strategy: Calculating the ROI in terms of shares instead of money. This is utterly meaningless, the argument goes. In real life there's nothing Barbie can do with shares, since every single other aspect of the economy is expressed in dollars, not in FENTs. That she has 174 more FENTs than she had eight months before doesn't help her a bit, particularly since the value of a FENT has fallen so much since. I could agree with this argument if it wasn't simply subjective. The exact same argument can be brought to invalidate Adam's strategy: To calculate ROI in terms of (Fiat) money is meaningless. A dollar's worth can, at any time, become half of what it was a year ago. Particularly since dollars, as opposed to FENTs, can be printed at will. This is even more obvious if Barbie, instead of shorting FENT, she shorts BTC (Bitcoin), which is inflation-proof. A FENT is a percentage of a real (even though it is a fake enterprise) business with real assets and real employees, which provides real goods and real services. Unless it's a complete fraud, the Free Market all but guarantees that a FENT has at least some value. A dollar, in the meantime, is nothing more than the spooky incarnation of a government bureaucrat's whim, and it only has value because in the shadow of his whim there lurkes a real policeman with a real gun and real bullets. True, the local grocer won't trade his bread in exchange for Barbie's FENTs, but he'd love to trade it in exchange for her BTCs. If they both had real bulletproof vests.
So, what's the risk of short selling? Again, it's the same as Adam's risk, swapping "Money" and "Shares". The risk is that the management of Fake Enterprises is actually good and the value of the dollar goes down. The lower it goes, the higher Barbie's loss, since she needs more dollars to purchase the shares she owes. The big difference is that, as opposed to Adam, whose maximum risk is "everything he invested plus interest", Barbie's maximum risk is infinite, because there is no limit on how good the management of the company, or how bad the managers of the dollar, can be. Therefore, for either of these reasons, FENT could go to, say, $20,000, at which point Barbie would need $10M to purchase the 500 shares. True, it might be the case that her salary at that point in time is $100M/year, but Barbie should not count on that. With risk that high, short selling is not for the faint of heart.
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C. Call Options
Charlie is bullish on FENT. Unlike Adam however, Charlie hates debt and is also risk averse, so he does nothing. Until one cold evening in March when he meets Claire who is bearish on FENT. It turns out that Claire loves living on the edge and is willing to take on Charlie's risk. In exchange for a fee of $0.80/share, she gives Charlie the option to buy from her 500 shares of FENT stock at $20, for the next six months, regardless of what the price of the stock really is. This gives Charlie the opportunity to wait until he can confirm his hunch about FENT going up, and only then make the purchase. At today's price! He immediately sees his strategy. He withdraws $400 from his credit line at 12% interest (a negligible $4/month) and gives it to Claire. All he needs is for FENT to reach his break-even price of $20.80 before September. If he exercises his option at that price (he buys from Claire the 500 shares at $20) and sells them right away at $20.80 on the open market, he makes an instant profit of $0.80/share which covers the $400 fee. Of course, Charlie thinks, he will not exercise his option at that ridiculously low price. He will wait for it to go higher and make $500 of pure profit for every dollar FENT goes up, because the contract compels Claire to sell those shares to him at $20, not a penny more, regardless of how high the price went. He just has to figure out when to sell, in order to maximize his profit. It has to be before September though, when the option expires. So, unlike crazy Adam who risks $10,000 plus huge interest fees, Charlie only risks losing at most the $400 fee if FENT does not go over the break-even price before September. That's manageable, even Charlie can handle that, especially since he has a strong feeling that FENT will go to the moon in the next couple of weeks. So, in exchange for the $400, Claire gives Charlie an option contract that specifies the following:
- the strike price: $20 (the price at which Charlie is entitled to buy the underlying asset);
- the premium: $0.80 (the fee charged by Claire for each share in the contract);
So, Claire now has $400 more while Charlie is the holder of a call option. Claire, the writer of the call option, hopes FENT stays below the strike price until September when Charlie's call option expires worthless and she's $400 richer. However, just like Barbie, Claire runs an infinite risk, since, in theory nothing prevents FENT from reaching, say, $20,000 before September. If it does, and Charlie exercises his call option, Claire is in big trouble, since, as the contract requires, she MUST purchase 500 shares at $20,000 and sell them to Charlie at $20 leaving her with virtually $10M loss. To hedge this risk, Claire could use a covered call strategy. Before we go into that, let's look at the other type of options contract.
D. Put Options
- the strike price: $20 (the price at which Dan is entitled to sell the underlying asset);
- the premium: $0.80 (the fee charged by Diana for each share in the contract);
E. Covered Calls
Let's go back to Claire who expects FENT to stay low. She runs an infinite risk if FENT starts going higher and higher. To manage this risk, she should cover her call option, by purchasing some of the shares she might have to buy in the future. So, when writing the call option to Charlie, she also buys 300 FENTs at $20, for $6,000. Let's look at possible outcomes from here.1. FENT starts going up and reaches $22. Claire admits she was wrong about Fake Enterprises and buys the remaining 200 FENTs for $4,400. Her call options contract with Charlie is now 100% covered in the event FENT goes really high.
1.a. FENT keeps going higher and Charlie exercises his option at $27. Claire sells to him her 500 FENTs at $20, for $10,000. She ends up breaking even, since the premium cancels out the $400 lost on the shares.
1.b. FENT starts going down and reaches $19 in August. Claire admits she was wrong about being wrong and sells all her FENTs for $9,500. In September Charlie's option expires worthless and Claire ends up losing $500 ($9,500 - $6,000 - $4,400 + $400). This is Claire's worst case scenario.
2. As Claire expected (she was right after all) FENT stays below $20. In August it trades at $19 and Claire decides to sell her 300 FENTs for $5,700, netting $100 ( ($6,000 - $5,700 + $400) of profit.
F. Covered Puts
Now, back to Diana who is bullish on FENT. Her highest potential loss is $9,600 if FENT goes to $0. To manage this risk, she should cover the put option she wrote to Dan, by buying some of the money she might need when Dan exercises his option. So, when writing the put option to Dan in exchange for the $400 premium, she also shorts 300 FENTs at $20, for $6,000. Let's look at .....
WAIT! WHAT? She BUYS some of the MONEY!!?? Well, yes. With the borrowed FENTs 🙄. If this is still unclear, ask Barbie.
Now let's look at the possible outcomes.
1. As Dan was hoping, FENT starts going down and reaches $18. Diana admits she might have been wrong about Fake Enterprises and shorts the remaining 200 FENTs for $3,600.
1.a. FENT keeps going lower. Now fully covered, Diana couldn't care less how low can FENT go, she is guaranteed not to lose a penny, even if it goes to $0. That's because she already has the $10,000 ( ($6,000 + $3,600 + $400) ) she needs for the purchase of the 500 FENTs from Dan when he exercises his option. And with those, she can close her short position.
1.b. FENT starts going back up and in September, when Dan's option expires worthless, it trades at $21. To close her short position, Diana needs 500 FENTs which she buys for $10,500. She ends up losing $500 ($10,500 - $10,000). This is Diana's worst case scenario.
2. FENT starts going up reaching $21 in September, when Dan's option expires worthless. To close her short position, Diana needs 300 FENTs which she buys for $6,300. Her profit is $100 ($400 + $6,000 - $6,300).
To conclude, whether a call or a put, covering an options contract reduces the writer's risk, by diminishing both the expected profit and expected loss.
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Where do investors get each month the FENTs they must pay in interest? To keep it simple, let's say the management of Fake Enterprises does a good enough job to keep the company at the same value for the next six months. Also, Fake Enterprises does not issue new shares, nor does it buy back existing ones, so the number of outstanding shares remains constant. All else being equal, FENT would stay stable at exactly $20.
On that fateful evening in March our investors decide they want to get into the game of FENTs.
- Adam wants to buy 500 shares.
- Barbie wants to sell 500 shares that she doesn't have.
- Charlie and Dan want nothing, they just bring each $400 into the game.
- Claire takes Charlie's money and wants to buy 300 FENTs to cover her call option.
- Diana takes Dan's money and wants to sell 300 FENTs, that she doesn't have, to cover her put option.
As it stands, everyone wants exactly what someone else wants to get rid of. Since the demand matches exactly the supply, FENT stays at $20 and all transactions are done at that price. The investors who want to just borrow FENTs and immediately sell them, simply write IOUs (I Owe You) to the seller. For example, Barbie borrows 500 shares from Adam, writing to him an IOU in exchange, and immediately sells them back to him in exchange for $10,000. Claire does the same with Diana. Since they are on the stock market, IOUs are now assets, and can be traded like any other type of debt assets. Let an IOU be a promise to return 100 FENTs, at 12%, before September. At the end of the day the situation looks like this:
- Adam has -$10,000 and +5 IOUs.
- Barbie has +$10,000 and -5 IOUs.
- Claire has +$400 and -3 IOUs.
- Charlie has -$400 and +5 call options.
- Diana has +$400 and +3 IOUs.
- Dan has -$400 and +5 put options.
Interesting to note that no FENTs have actually changed hands and yet all the guys above are now investors. In April, however, some interest is due. Barbie must pay 5 FENTs to Adam while Claire must pay 3 FENTS to Diana. As opposed to the Government, who can simply print the dollars they owe, or rob Peter to pay Paul, Barbie and Claire have no other choice but to purchase the FENTs. Which constitutes an extra demand. The Free Market does create the required supply, but only at the price of FENT going up.
So, FENT went up for no other reason but the interest owed on borrowed shares, or in other words, the cost of time. Those IOUs are the equivalent, and the expression, of inflation in the world of stocks. They are Fiat-shares, so to speak. This is more bad news for investors who are short on FENT. The price of FENT increased precisely because there is short interest in it. The more investors believe FENT will go down, and act on that belief by shorting the stock, the higher the stock has the tendency to go.
It gets worse for them as time goes by. In August FENT trades at $22. Adam would be only a little richer if he sells his shares, so he waits. So does Charlie, who makes almost no profit if he exercises his call option. Claire sticks to her plan and covers the rest of her call option by purchasing the remaining 200 FENTs. Dan has lost any hope and says good bye to the premium he paid to Diana. Diana closes her short position as planned, for a small profit. Barbie, however, whose naked short gives her nightmares even during the day, has started taking anti-depressants. Eventually, she WILL HAVE to make the dreaded purchase. She could start now, by buying some of the shares at a (small) loss, but she's stubborn. It will go down! She can feel it!
The key takeaway from all this is: Investors who are short MUST purchase the FENTs they've borrowed as well as the FENTs they owe as interest. And here is the question few are willing to ask: What if no one is selling?
Impossible! the conventional wisdom declares. This kind of short squeezes have been tried over and over with no real success. There are just so many rules in place and so many people involved, there is no way this can occur to any significant effect. First, the Free Market and the profit motive ensure that the higher the price goes, the more sellers will be willing to sell, establishing, as always, an objective balance between supply and demand. Then there is the logistics of it all. How would somebody convince all, or even most, owners to stop selling? Impossible! Then there are the brokers and trading companies. They charge fees for transactions, and most of the time do not even allow naked shorts and uncovered option contracts, they require guarantees, and collateral. Impossible! And then there is the guardian and guarantor of fairness and justice - The Government. It would never allow for such an aberration. It runs dozens of agencies, employs hundreds of auditors, and has unleashed thousands of rules and regulations to oversee this particular economic sector. So, yeah: IMPOSSIBLE!
Oh, yes, POSSIBLE! And it did happen. And Wall Street lost. A LOT!
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The GameStop Short Squeeze
In late 2019 Game Stop (GME) was close to bankruptcy, everybody was in agreement it was going to go bust. Therefore there was a lot of short interest in GameStop. Melvin Capital and Citron Research among others were heavily shorting its stock. At one point, GME was sold short 140%! That means that for each existing share of GME, 1.4 shares were owed. For every 100 existing shares of GME there were 140 IOUs.
It was around that time when a guy, known as Roaring Kitty on YouTube, and as DeepFuckingValue (DFV) on Reddit, bought $50,000 worth of GME call options. DFV thought GME was undervalued and that it was going to go up to a level where he would exercise them and buy a decent house. In less than two years, GME went from $0.80 to $80. DFV bought a $7.2M mansion in Massachusetts. How was this possible, Mr Market? How did he know not to exercise his options at $8, for more than enough to buy the house of his dreams? How come GME did actually go that high since GameStop was close to bankruptcy to begin with? Well, DFV had all the tools needed to overcome all those obstacles and safeguards put in place by all kinds of people and organizations, and organize a squeeze. True, all his stars aligned as well.
Broker fees? Virtually zero. He used Robinhood, which is not a financial institution, but an app.
Collateral? None needed. $50,000 is the most he could lose, he probably borrowed that money from the family.
Government oversight? None. They keep their eyes on the big guys, not on a guy in a basement.
Logistics? Easy - Social media. Melvin Capital and other Wall Street institutions had underestimated the power of the empty word. A flashy YouTube channel featuring cute cats, and an aggressive r/wallstreetbets subreddit constantly dangling in front of everyone's eyes the riches that could be made, is all you need. Particularly when the pandemic had everyone locked down, schools were closed, and the Millennials had not much else to spend their stimulus checks on. So they didn't need much convincing to buy. They did need convincing to hold and not sell or exercise their call options. Why? To squeeze the short sellers. To stick it to the rich. To show Wall Street how it's done. And they held. The more they held, the higher GME went. The higher it went, the higher the pressure on short sellers to buy, pushing GME even higher. The squeeze worked. In its wake, Melving Capital shut down, after losing at one point $1B/day.
After all this investment advice, here is my legal advice as well. Sue me. Was this squeeze legal? Most likely not. DFV truly believed GME was undervalued, so the initial purchases were legit. The squeeze itself, however, is clearly stock manipulation which is 100% illegal. If this was done by Wall Street, lots of CEOs would have been sent to prison. But not DFV, a regular guy with student loans. He was initially poor, therefore right. Right? Later, the Government did investigate him and others, no charges were laid. There was an unequivocal conflict of interest between Robinhood and their market-maker partner Citadel who was losing money because of the squeeze. The two agreed at one point to restrict trading, and were subsequently sued by traders for collusion 🤣 .
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So, that's it! Let's start making some money 😎😏
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