LogFAQs > #951406204

MajinZidane posted...

Very interesting information. Are you just gathering this information, or have you drawn any conclusions based off of it?

I don't know. What I really want to know is how many of those calls are properly hedged with other calls (like in a spread) and how many are naked. A single block of 100 shares could potentially support a long chain of calls. Like, A writes a call covered with shares. B buys the call and uses it to write another call at a different strike price or expiry date, using the first call as a hedge. C buys the second call and writes a third using the second as a hedge. And so on.

Hard to tell how many layers deep the chains have gone. Also, supposing the chains are very deep and the calls are properly hedged, I'm not sure about how much chaos having this kind of leverage could have. Like, suppose Z is the end call buyer, and he decides to exercise his call. Y must now deliver shares he doesn't own, but he does own a call from X, so he exercises that call to obtain the shares he needs. X doesn't have the shares either, but he owns a call from W, so he exercises that one. And so on back to A, the only person in the chain who actually owns shares.

In theory, this should work smoothly and in a theoretical world, from the point of view of A and Z they may not know that A was not directly selling his shares to Z. I suspect that either there are a significant number of naked calls or the chains of hedges are not working all that smoothly though, as GME has experienced rather a lot of gamma squeezes including that recent one that went from $50 to $200. That is an ultra rare event normally while for GME it's happened like 5ish times in 8 weeks.

Where I'm having trouble is understanding the motive of the shorts in the world where they have sold many naked short calls. I would have much more confidence in a trade if I can come up with a reasonable motive for why someone on the other side of the trade would act the way they do. For example, with travel stocks last year, people sold because they were afraid and risk averse. They wanted stable investments in blue chip companies and they got companies losing billions per month due to a strange new pandemic we knew little about. So they sold out of fear, even though they got very poor value for their shares. They didn't care so much about the value because the stock had left the risk class they were comfortable with. They got to avoid the risk of travel companies going bankrupt, and people who bought got the benefit of earning that sweet risk premium.

For GME, I have a hard time understanding why a fund would engage in what appears to be such a manifestly stupid trade like shorting GME, either directly or by writing calls, which would support the theory that maybe they are properly hedged. As a rule, if you are thinking that "the other guy is stupid" that is a big red flag that you are the one who is missing something. The best I can think of as a rationale for them in the world where they aren't close to properly hedged is that the hedge funds doing this really believe that retail traders are stupid. That, or the people managing the funds aren't really concerned about losing money for their investors because it doesn't make much difference to how much the managers make whether they come in slightly under their hurdle rate or lose 50% of equity under management - they only care about gains, not losses, so they're happy to take on more risk without getting more risk premium. That, or our country's reaction to 2008 (bail out the big financial institutions) has trained a generation of finance people in the belief that the government is there to backstop them.

I do find the resemblence of the Jan 13 - Jan 21 price and volume movement and the Feb 24 - now price and volume movement striking, and this trade remains asymmetric and incredibly interesting, so it's worth having some money in it to me. I follow the Kelly Criterion pretty strictly so the asymmetric nature of the trade is also a reason not to put a lot of money in it.

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September 1, 2003; November 4, 2007; September 2, 2013
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