GME stock alert: Investors betting on ‘accidental’ squeeze

When GameStop (NYSE:EMG) reports earnings on March 21 after markets close, Wall Street is expecting a wet firecracker. Analysts forecast revenue of just $2.18 billion, 3.2% less than last year’s figures. And net profit is expected to show a loss of -$48.5 million. Fewer new console games…fewer stores…bad news from vendors…we probably don’t see any fireworks this quarter.

But try telling that to any GameStop investor. By midday Monday, no less than 22,000 short-term bullish options had already changed hands. And the number of outstanding appeals from March 24 has sparked open interest increase as we get closer to their expiration date.

This is because GameStop has attracted the most interesting investors:

Speculative day traders looking to profit from short-term volatility.

These traders have already driven GameStop shares up 7% since Thursday. And although speculators tend to sell immediately after earnings, the retailer’s weak float makes an “accidental” short squeeze in GME shares much more likely than people think.

GME stock and the risk of gamma compression

Imagine an ordinary short press. Short sellers sell too much of a company’s stock and are then forced to close when prices start to rise. That implies purchase stock (since short sellers initially have a negative position), creating a feedback loop of more buying.

GameStop experienced this in January 2021, when over-eager hedge funds shorted around 93% of the company’s free float. Reddit investors have piled in, and the title’s subsequent 20-time rise now has multiple movie deals in the works.

Today’s sequel is slightly different. GameStop has “only” 22% of its shares sold short this time.

But the risks of a short squeeze remain just as high.

About a quarter of GameStop’s float is now registered directly with its transfer agent – ​​a product of retail investors reducing the number of short stocks available. And call options now play a leading role. These leveraged bets mean that even $100 in call buys can turn into $1,000 or more in market maker buys.

GameStop’s short stock availability hit zero on March 20. Source: Fintel.io

Here’s why. Imagine that we are one New York Stock Exchange market maker whose only job is to execute options orders. We love our job and we do it pretty well.

One day, a bettor asks for 1,000 call options on GameStop with a strike price of $20. We both know that GameStop reports profits within 24 hours and that a $5 increase in stock price will make those calls worthwhile. negative $2 to call us sellers. (This is the difference between the $20 strike and the $22 GME price). A $10 increase in the stock price would trigger the -$7 option, and so on. (Don’t worry about the math…it’s that next part that’s important)

As market makers, we do two things to reduce our risk:

1. We ask for a large premium… say 53 cents. Even if prices spike to $20.53, we can still walk away without any losses.
2. We buy shares in GameStop. A more advanced technique is to take the $53,000 premium (53 cent premium * 100 shares per contract * 1,000 contracts) and invest a portion of it in the underlying GME stock. In this way, if the actions TO DO rise above $20.53, we can offset the losses from our short calls with the profits from our long stock position.

This second part is pretty clever…until everyone starts doing the same. Options require more the positions offset each other as they move closer to the money, causing market makers to buy more shares as prices rise. This causes even more buying pressure. Lo and behold… gamma compression.

Call option buyers might “accidentally” initiate another GME squeeze without realizing it.

Wealth Risks

None of this, of course, changes GameStop’s long-term outlook. Even whether shares went to $20…$50…$100 (and management increased their number of authorized shares over time), there’s not much fresh capital can do. The company already has about $1 billion in cash and virtually no long-term debt outside of operating leases.

GameStop’s new management also failed to reinvigorate the company. Its late push into NFTs, Web 3.0 games and cryptocurrency failed. And revenue continues to decline as gamers migrate to buying digital versions. The company needs an Elon Musk-like personality to shake up its business.

Then there is the question of pleasing short-term traders. In February, a similar flurry of near-expiry options buying sent stocks of other meme stocks AMC Entertainment (NYSE:CMA) from $6 to over $8. But prices soon fell again as speculators cashed in on their calls. AMC is now trading for around $4.

Gamma squeezes, it turns out, cuts both ways.

What’s next for GME Stock?

In the predicted event, GameStop’s struggling business will disappoint relative to Wall Street’s fourth-quarter estimates. Many other retailers have already announced poor fourth quarter results and even worse forecasts. These are negative signs for GameStop; stocks could fall below $10 on bad news.

But short sellers need to understand that this is a gamble not worth taking. If GameStop surprises Wall Street, heavy buying could trigger gamma compression. And if that happens, you can be sure that Seth Rogen will have another memestock movie script on his hands.

Bottom line: Watch out for a potential squeezing of volatile GameStop stocks.

As of the date of publication, Tom Yeung did not hold (either directly or indirectly) any position in the securities mentioned in this article. The opinions expressed in this article are those of the author, subject to InvestorPlace.com Publication guidelines.