Risk Management in Trading: GameStop Edition

Trading is a game of survival against the twin threats of long-term inflation and capital preservation. Achieving a balance between the two ultimately determines success. To beat inflation, you have to take risk. But to protect your capital, you have to understand the role of risk management in trading.

GameStop: the perfect short (2015 to mid-2020 edition)

GameStop is the latest example of a great short that could have made a trader money for 5 years. If you’re somehow unfamiliar with the company by this point, GameStop is a purveyor of games, gaming consoles, and accessories, located in lots of abandoned malls across the country. As you can imagine, selling electronic games in a retail location in a mall has not been the strongest business model for a while now. Kinda like Blockbuster video but 5 years later. And the stock price from 2015 to 2020 reflected it:

$GME 2015-2020

A lot of people saw the trend and decided to pile onto the short to ride it down. By the end of 2020, GameStop was one of the most widely shorted stocks out there with more than 100 percent of its outstanding stock sold short. Beginning in 2021, some prominent short activists ratcheted up their campaign to publicly smear the company to try to make some money as part of their normal playbook to drive prices down.

Then the degenerates at r/wallstreetbets got involved.

The whiff of fundamental value combined with a large group of individual traders who had a fair amount of nostalgia for the retailer, access to leverage via call options, a fair amount of derision for hedge funds, and a gambler’s desire for entertainment, collectively created a massive short squeeze for GameStop reminiscent of the one Volkswagen experienced in 2008.

$GME Short Squeeze

The stock price went from ~$20 at the start of the year to $342 less than a month later. The even crazier part for traders is that just yesterday the price closed around $140 then gapped up to the mid-$300s at the open today, more than doubling the price overnight. If you tried to be a hero and shorted at the end of the day yesterday you’re already sitting on a 100 percent loss.

Trading Risk Management Tools

Which brings me to my PSA for anyone who is new to short selling and wondering how to avoid getting blown up by the next GameStop. There are 4 basic tools:

Position Sizing

The gambler who buys GameStop today is probably going to be sitting on a 90 percent loss one to three years from now. Even today, Volkswagen’s stock price is still ~80 percent below the all-time high it experienced during its short squeeze 12 years ago. And Volkswagen is a great business.

However, the path of that 90 percent loss for today’s buyer is anything but certain. It’s entirely possible that GameStop could double tomorrow and then double again the next day before the short squeeze reverses. And this is what keeps traders coming in – they’re hoping they can sell to a greater fool.

If a short seller keeps his positions small, even if he shorted the stock at $20, he still wouldn’t be at risk of a forced liquidation by his broker due to a margin call. His portfolio would be down ~10 percent for the year assuming a 1 percent position size, but he’d survive to trade another day.

Stop Loss

While an overnight gap that doubles the stock price hurts, and probably blows past a short seller’s stop loss, using one automatically saves you the mental anguish of deciding whether to hold or bail. You’ll notice that Citron exited the trade at a 100 percent loss. I don’t know their normal exit strategy, but a 100 percent loss, or less, as a stop loss on a short makes sense as you can only ever make 100 percent on a trade (simplistically – not counting the cost to borrow that usually spikes right before a BK).

Options

On a normal, non-sensationalized short it’s possible to use options to limit your risk. There’s infinite ways to do it – you can buy a put that’s ATM, ITM, or OTM. You can short the stock then buy a call, or you could construct vertical spreads with puts or calls while limiting your risk.

The only issue with this approach is that it takes a serious bite out of your returns and that’s assuming the options pool is deep enough to get a good fill at the quantity you need.

If you want to be a hero and try to short GameStop at this price, trying to buy a put option to do it is highly risky. And by highly risky I mean it’s just plain dumb (I’m not going to sugarcoat this). As I’m writing this, the July 2021 $320 put is selling for $234 with GameStop’s stock price at $333. And if you try to straight up short it at this price: the cost to borrow is ~26 percent annually. So even if you short it today, survive the end of the short squeeze, but the price takes a couple years to get back down to $20, you’re still barely going to make any money.

Avoid Highly Shorted Stocks

The easiest risk management tool to apply is simply avoiding highly shorted stocks. There are tons of stocks out there that are struggling that you’ve probably never heard of. As a quick example (and I know nothing about the fundamentals of this stock and this isn’t a recommendation to actually short it), Spire Inc took a hit during the pandemic and is struggling to recover:

Spire Inc.

You’ve probably never heard of it, the short interest is ~2 percent, and there’s currently no cost to borrow shares to short at my broker.

These types of companies’ fortunes will ebb and flow. While they won’t all go to zero in a given year, a lot of them will look like GameStop before this month – a slow decline over a multi-year period with repeated failed attempts to recover. By trading obscure companies that people are indifferent to you avoid the crowded trades, the short squeezes, and the high borrowing costs.

And you’ll also avoid the new risk of r/wallstreetbets.

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