Blog January 2021

Jiu-Jitsu Comes to the Stock Market

by Jan Kregel

The core philosophy of this Japanese defensive art used by the weak against the stronger Samurai is to mobilize the opponent’s greater force to your own advantage. Many have criticized the run-up in the quotation of the GameStop shares as a violation of market principles or regulations. Far from it, it simply represents the fact that day traders may be dumb money, but they have understood how to apply jiu-jitsu.

If the intent was simply to profit from trading the stock, no retail trader could ever compete with the institutions. To attempt to directly manipulate the price of the stock through outright purchase or sale would be impossible. The strategy that was used was simply to recognize, as Softbank had done earlier in the year, the nature of market hedging.

There is a myth that hedging can eliminate risk. This almost never happens, unless there is a perfect match between risk of gain and risk of loss. In all other cases, hedging requires compensation to transfer the risk—to those more able to bear the risk, as Greenspan would say. After the 2008 financial crisis, we learned that ability had nothing to do with it; it was who was willing to bear the loss, and most were not able and required the government to bail them out.

So in the run-up in the market quotes of GameStop shares, this was not really a question of the dubious behavior of a bunch of day traders; it was an application of market knowledge of how financial contracts work in practice. The start was to buy a stock in a company with doubtful prospects that was under substantial short-side pressure from major institutions and hedge funds—information that is public. The jiu-jitsu was in the next step: to buy out of the money call options on the stock. To appear stupid! Who would buy a stock that informed opinion believed about to crash, and even worse, then buy a call on the stock and pay an options premium for the privilege to buy the stock at a price everyone expected to be far below the strike price of the option? It looked like a certain loss to the day traders and a gift to the institutional short-sellers who got options premia to help pay for their bear raid on the stock.

However, the writer of an option agrees to provide the stock if the option market price finishes at a price above the “strike” price agreed to in the contract. But this is what the short-seller does not have, because he has to borrow the stock from an existing holder in order to sell it before it can be bought back at a profit. Further, the writer (seller) of the call option runs a risk that the stock price will rise and the stock must be delivered to the option holder at a loss. It is thus normal for the option writer to use what is called a delta hedge, that is, to acquire a proportion of the contract value of the stock just in case. If the price of the stock rises towards the strike, the writer would buy in more and more stock, which offsets the short sales and further depletes the amount of stock available in the market. If the dumb money continues to buy, the price continues to rise and more options writers have to buy the stock to hedge their positions. The delta hedges thus support the day traders in pushing up prices. As some of the short-sellers abandon their positions, they also have to buy in stock to cover the stock they have borrowed. Now the dumb day trader money has its jiu-jitsu mojo working, as the institutions and hedge funds have to join in the buying spree. The faster the price rises, the faster the delta hedge purchases have to increase, producing what is called the gamma squeeze (technically, the rate of change of the appropriate delta hedge purchases) until the losses of the short-sellers become so large that the whole market is buying the stock that everyone knows is massively overvalued but also increasingly scarce. The scissors of supply and demand is at work, but in the wrong direction. The retail buyers no longer have to put money on the table, they have organized the Samurai short-sellers to commit hara-kiri. The retail traders are only dumb money if they fail to complete their jiu-jitsu takedown and exit the market with their profits before the game is called and the Samurai appeal for government support.

Many argue that this is in some way contrary to the moral of the market and its supposed fundamental purpose, which is to raise capital or provide efficient prices. The stock buybacks of the major corporations since the financial crisis put paid to the idea that corporations raise capital in the market—they have been busy giving capital back to investors in order to manipulate their stock price. And the crisis itself suggests that the market has never done a very good job of evaluating the value of stocks—viz. The Big Short of recent memory and the collapse of the British pound, or any financial market history book relating the history of stock price manipulation. The collapse of the pound was exemplary, as hedge funds pushed the sterling exchange rate to the point that most writers of knockout options had to close positions by selling sterling. Some of these attempts at market manipulation were clearly illegal and took place before modern regulation was in place, but most complied with existing market regulation. They were simply astute application of the rules of the market. GameStop’s price moves are not the fault of the day traders or the lack of regulations, it was simply confirmation of the fact that markets may create instability and the day traders’ recognition of how to do jiu-jitsu on the Samurai institutions. It has been done before and it will happen again.

Jiu-Jitsu Comes to the Stock Market

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