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There's a New "Short Burn of the Century"

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GameStop (GME - Free Report) shares continued their incredible rally on Wednesday, hitting an intraday high of $380/share in events that have taken the title of the “short squeeze of the century” away from Elon Musk and Tesla (TSLA - Free Report) .

Musk coined that term to describe what he expected would happen to those who were betting against Tesla as the company was ramping up production of the mass-market Model 3. It was a make-or-break moment for Tesla and the company delivered, raising production figures to 500,000 vehicles annually while establishing a global manufacturing, sales and charging network footprint that’s the envy of all other automakers.

Investors pushed Tesla shares sharply higher and the shorts did in fact get burned. Since the beginning of 2018, Tesla shares are up 1,200%.

There are legitimate questions about whether Tesla deserves its lofty valuation based on current fundamentals, but based on their incredible accomplishments so far, it’s certainly possible that they’ll continue to grow at a torrid pace - making today’s share price a bargain.

With an already successful and profitable auto business and multiple “irons in the fire” for the future of transportation and energy, Tesla is an example of a stock that has ridden a wave of investor enthusiasm, even as many professional traders expressed their doubts by going short, getting burned in the process.

GameStop is a completely different situation.

While Tesla offers the vehicles and alternative energy solutions of the future, GameStop offers the video game selling methods of the past. Other than the addition of Chewy (CHWY - Free Report) founder Ryan Cohen as a member of the Board of Directors (while also amassed a 13% stake in the shares), nothing has fundamentally changed at the company since the stock was trading in the mid-teens.

Instead, the meteoric rally seems mostly to be the result of a large number of individual investors buying up the shares after communicating with each other in online forums, most notably Reddit’s Wallstreetbets discussion. Traders on the message board encourage each other to hold the shares they already own and never take profits while digging into savings to buy more and force hedge funds who are short to cover their positions.

Notable short sellers Citron Research and Melvin Capital Management have already exited their widely publicized short positions in GameStop. Citron’s Andrew Left pulled the plug after receiving death threats to himself and his family. Ironically, in hindsight, that move saved him a considerable amount of pain because he covered before the shares broke $100.

Melvin Capital received a supplemental investment from Hedge fund titans Ken Griffin and Steven Cohen to stanch steep losses, but Melvin ended up exiting their short position a day later anyway.

On the Reddit forum, you’ll find enthusiastic traders who are up tens or hundreds of thousands of dollars on the trade and have taken to speaking in lofty tones about cleaning up the scourge of short-sellers on Wall Street as they enrich themselves. Their earnestness about the value of their cause is exceeded only by their occasionally glaring lack of knowledge about market mechanics.

I don’t know when it going to happen, but I'm pretty sure most of those investors are eventually going to get killed on this trade. Buying shares of a sketchy company with the potential to become a Cinderella story on a big turnaround is a reasonable strategy. It’s risky and should probably involve only a small percentage of the average investor’s total capital, but it has certainly worked in the past.

When a trade like that results in 100% profits in a matter of weeks, reasonable investors will take some or all of their profits and consider the trade a huge success. The Wallstreetbets forum includes many of participants who bemoan the fact that they sold out between $30 and $70/share on the first runup, missing the truly parabolic portion of the subsequent rally. They might well turn out to be the smartest traders involved in this trade.

Anyone who’s paying over $300/share for GameStop is taking a huge amount of risk for a dubious chance at a big reward. With a market cap of more than $25 billion, to rise another 67%, the company would have to surpass the value of a company like Ford Motor Company (F - Free Report) with its $42B market cap.

For comparison, Ford has annual sales of $116 billion in a poor year. GameStop’s sales? A measly (and shrinking) $5 billion.

Those who are buying GameStop call options instead of shares because of the limited risk and higher leverage afforded by options are actually taking even more risk than if they had made an outright purchase. With implied volatilities of 600% or more, those options are incredibly expensive. An at-the-money call option with less than 2 days remaining is currently trading for more than $100. That’s more than a share of stock cost just two days ago; and if the rally doesn’t continue – hard – from here over the next day and a half, the buyer loses the entire premium.

Some of the upward momentum has been provided by options market makers re-hedging their positions, but there’s an upper limit on that activity. If we haven’t reached it yet, it’s got to be close. An option can’t have a delta higher than 100, so unless traders keep buying these expensive calls with strikes in the 300s and 400s, the "negative gamma" momentum will peter out.

Again, I obviously don’t have any idea when this will end, but I have a pretty good idea how it will end.

The internet forum momentum story isn't even new. Google "Iomega" if you don't remember the first ever chat room boom and bust.

I love the story about the democratization of the financial markets as much as the next guy, but it’s simply not all that realistic. It’s virtually impossible to “corner” any market. There’s too much capital out there to prevent it - and crush you in the process. There are many situations in which it works for a while – usually because of an ephemeral mechanical anomaly – but few traders have ever gotten out with their profits.

Right now there are mechanical reasons why some of the weaker shorts have been forced out, but there are hundreds of billions in AUM at hedge funds who have stayed out of the fray so far. When trading firms that have true edge in the markets see something weird happening, their first instinct is to stay away the same way a champion boxer doesn't want to get into an alley fight with broken bottles.

If and when they decide there's too much money on the table not to make a grab for it, they can squash this rally, and it will end in a hurry.

For those who are profiting from the chat room dynamic, I’d encourage you to read “Reminiscences of a Stock Operator” by Edwin LeFevre, in which a fictionalized version of legendary trader Jesse Livermore lays out his recommendations for taking trading advice from others.

Livermore cautioned that anytime someone told you that it was time to buy, sell or hold a stock, that person probably had his own interests in mind rather than yours.

For anyone sitting on huge profits in GameStop long positions:

A)      Congratulations for hanging on this long.

B)      Carefully examine the potential motivations of anyone you don’t know personally who’s giving you advice about when to sell your shares. Be especially suspicious of anyone encouraging you to buy more up here!  When they decide to get out, do you think they’re going to tell you first, or simply leave you holding the bag?

Please make sure you're thinking for yourself.

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