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A veteran options trader breaks down the intricate strategy that Reddit traders used to outsmart Wall Street's bet against GameStop — and shares 2 ways the parabolic rally could permanently alter the stock market

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Daytrader Damian McVeigh sits in front of computers with his daughter Avril at home during the coronavirus disease (COVID-19) outbreak, in Belfast, Northern Ireland June 16, 2020. Rachael McVeigh/Reuters

  • Steve Sosnick is the chief strategist of Interactive Brokers and head trader of its trading unit Timber Hill.
  • Sosnick breaks down the short squeeze and gamma squeeze Reddit traders put in place for GameStop.
  • He also shared how the parabolic moves of these meme stocks could permanently alter markets.
  • Visit Business Insider's homepage for more stories.
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Markets were possessed by GameStop mania this past week, and it was hard not to pay attention.

The brick-and-mortar, video-game retailer that was once left for dead in the coronavirus-induced lockdown has surged over 1,300% in the past month. 

GameStop's stratospheric rally, mostly driven by Reddit's WallStreetBets traders, upended hedge funds such as Melvin Capital and Citron Research. According to data provider Ortex, GameStop short-sellers have lost around $19 billion in 2021.

And that's not all. 

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After Robinhood joined other major brokerages on Thursday to restrict trading in GameStop, allegedly causing the stock to plunge as much as 60% before resuming its rally, the Securities and Exchange Commission said it was "closely monitoring and evaluating the extreme price volatility" of these so-called meme stocks. Congressional Democrats prepared to hold two hearings into Wall Street practices and online trading. 

So how did it all happen? While Reddit traders have often been described as unsophisticated and inexperienced young people trading on stimulus checks out of their parents' basement, the strategy they employed — a short squeeze that eventually turned into a Gamma squeeze — is actually quite intricate. 

To figure out how these smallish retail investors outsmarted hedge fund managers, Insider spoke with Steve Sosnick, the chief strategist at Interactive Brokers and head trader of Timber Hill, the firm's trading division.

A veteran trader with over three decades of options and stock-trading experience, Sosnick knows a short squeeze and a gamma squeeze when he sees one. 

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What is a short squeeze?

To short a stock, investors need to borrow shares from their brokers. Then they will go on to sell the shares to others in the market with the expectation that the shares would fall.

Once that happens, these investors will hope to buy the shares back at a lower price than what they have paid to borrow the shares in order to pocket the difference when they return the shares to their broker. This is a classic "sell high buy low" short-selling strategy.

The process may seem harmless enough, but the risk is that investors will have to buy these shares back at some point regardless of the price. Even if they choose to not buy back these shares immediately, they will have to post enough money into their accounts because the broker is lending the shares on a collateralized basis and they want collateral for their loan. 

That's why as the shares keep going up, brokers will ask the short-sellers for more money. 

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Sosnick adds that another pitfall for a short-seller is that if the lender of the stock sells, then the short-seller will have to go find new shares to borrow. If the short-seller can't find new shares to borrow, they have to go out and buy that stock whether they want to or not.

"Those two elements are what contributed to a short squeeze. So either the stock becomes too hard or too expensive to borrow or the stock starts to rise too quickly," he said. "Then the short-sellers are forced to cover their shorts. And if it happens rapidly enough, it creates a feedback loop and becomes a self-fulfilling prophecy."

And that's how the GameStop saga started. 

The Reddit traders pounced on GameStop because it was one of the most shorted stocks on Wall Street. At one point, the short interest of the stock was 144% of its available shares for trading.

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The massive short interest in GameStop meant that retail traders could collectively buy into the stock, push its share prices higher, and force short-sellers of GameStop to buy back shares in order to limit their losses. 

That's exactly what happened, except the losses were so enormous that Citron Research, for example, had to cover the majority of its GameStop short positions at a 100% loss.

What is a gamma squeeze?

The short squeeze on GameStop turned into a gamma squeeze when Reddit traders started to use call options, a leveraged way to bet that stocks will go up. 

To understand what gamma is, investors need to look at delta, which measures how much you can expect the option to move for a given move in the underlying stock. 

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For every call option buyer, there's a call option seller or the dealer, who needs to hedge their sale of the call option by buying the underlying stock; that's called a delta hedge. 

If delta remained unchanged for the life of an option, hedging would be a fairly simple activity. But delta tends to change, and that's where gamma, which measures delta's rate of change over time, comes in. 

As the value of the underlying stock gets closer and closer to the call option's strike price, dealers will have to buy more and more stock to hedge, pushing up the stock price even more. That's known as a gamma squeeze, and that's what retail traders exploited to their advantage.

"Whoever is short the call option finds themselves exposed at a greater and greater level to the movement of the stock because the delta of the options changed and the price of the stock went up," Sosnick said.

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"So anybody who short those calls, who needs to be hedged, finds themselves in the situation that they now have to buy more stock. Taken to the extreme, that becomes a similar type of feedback loop to the short squeeze."

Two potential changes for the market

Short squeezes have been around for as long as investors have shorted stocks. Even gamma squeezes have been used by retail traders to bid up stocks before. But the GameStop mania could have long-term implications for the markets. 

"If a strategy works, people tend to keep using it until it stops working," Sosnick said. "This has been one that's worked out spectacularly well, so in the short term, markets adjust."

He thinks there will be two main adjustments. One is that investors will be more reluctant to short and short-sellers will be more reluctant to take extreme positions. 

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That prediction has already come true as Andrew Left of Citron Research announced on Friday that he will stop publishing short-seller research after 20 years. Instead, he will pivot to long-only "multi-bagger opportunities" for individual investors. 

The second consequence is that investors will likely see call option prices systemically higher relative to their stock counterparts.

Sosnick explains that while there's been a natural demand for put protection and a natural supply of above-market call option writers, there's now a sea change in the amount of demand for out-of-the-money calls given the retail fervor toward buying such call options. 

"What's the logical thing for the market to do in that situation? Systematically raise the price," he said. "There's always a price at which someone's willing to sell, but if the supply-demand equation has changed, systemically people are going to demand more money to sell the options."

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