Worried about a GameStop re-run in India? Shubham Agarwal tells you how to guard against it

What leads to GameStop-like price moves?

Hedge funds short stocks with weak valuations by borrowing shares from the market to benefit from a correction in stock price and then eventually reverse their trades. But, while the trade is open, there is also an obligation to return the borrowed shares and the way to do is to buy it back from the market.

First time ever to this quantum, small investors used social media to cartelise and buy the shares, triggering an artificially created chain reaction where even the hedge funds had to jump to cover their short positions, losing billions of dollars.

Also read: GameStop | How rookie investors beat seasoned counterparts at their own game

What is short-squeeze?

Markets move in trends and when stocks with weak fundamentals start correcting, participants set up trades to benefit from this but excessive selling can lead to a point where the stock is significantly undervalued and some reverse action due to buying interest of few participants can cause a reversal in prices, forcing some short-sellers to cover the increasing price and in a chain reaction can lead to a massive spike in the price of the instrument.

Also read: India's small investors rush to join GameStop frenzy

Hedging risk and upping the guard 

Open Risk is a function of “greed” than a “necessity”. Surprisingly, almost all collapse-case studies could have been prevented by a “discipline of choice” to keep the risk locked yet investors and traders often ignore history. In today’s world, with sophisticated financial instruments, a risk can be hedged by multiple means and safeguarded from a black swan event.

Just like you buy life insurance to cover personal risks, it should be a rule of thumb to buy a protection in “trades where you can lose more than your capital invested”.

Strategies like shorting naked options, shorting futures, short selling with borrowed shares, etc can easily be coupled with a very small safety premium of hedge by multiple means, easiest being buying a deep OTM option.

Also read: Explained: Why GameStop’s stock surge is shaking Wall Street

Similar scenarios in Indian markets

With the phenomenal popularity of weekly options trading in the index options on the expiry day, a squeeze is very often witnessed in these instruments. The market tends to build “consensus trades” by watching common data points like open interest of strikes and writes common strikes, making it obvious levels.

To amplify this, traders, especially retailers, put a large bet, borrowing from their brokers in the form of leverage trading. This sets in perfect parameters for a squeeze and in instances where the underlying approaches the level it generally tends to have a chain reaction with a significant squeeze.

What if short-squeeze happens, can regulations prevent it?

It’s pretty ambiguous to isolate and find trades that were a squeeze and with common rules to the game, where everyone has access to market data, it would be more of an analysis flaw or discipline flaw than the market microstructure.

So, it’s very unlikely that regulations or regulators will be able to prevent a short-squeeze. Having said that, often other means are implemented to prevent investors interest in these scenarios:

1. Raising required margins: This discourages traders from taking abnormal positions, as they have to commit a lot of capital upfront

2. Circuit filters: These help during a sudden spike in prices due to short-term imbalance between supply and demand and makes it difficult to manipulate prices.

Takeaway

From Dyut Sabha from Mahabharata times of 5,000 years back to 1998 LTCM to 2018 Optionsellers.com and now 2021 GameStop, one learning is common—“Open Risk” has always led to a collapse. Have you ever heard of a long-term success story with open risk? I am yet to hear one.

So, let’s learn from history so that we don’t repeat one.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.