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The Worst Mistake GameStop Investors Can Make Right Now

By Chuck Saletta - Jan 31, 2021 at 2:30PM

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Recognize the risks inherent in investing in a stock like this one or its options.

Shares of GameStop (GME -3.56%) have been on an astronomical rise recently as a short squeeze and a gamma squeeze combined to force a lot of buying of its shares. While those who bought in early in anticipation of such an outcome may be sitting pretty right now, current investors should beware. Squeezes like this rarely end well, and the same forces that caused its shares to skyrocket can cause its shares to fall just as far, just as fast if not faster.

Indeed, the worst mistake GameStop investors can make right now is to assume the party will continue. It very likely won't, and those who invest believing it will are the ones in line to get hurt the worst when it all comes crashing down. There are at least two huge risks facing GameStop's shares that can cause the whole thing to come tumbling down. Failure to recognize them will cause trouble for those left holding the bag when the whole house of cards collapses.

Chart of downward pointing stocks with an investor looking sad

Image source: Getty Images

The options at the center of that gamma squeeze

The very stock options that helped drive the gamma squeeze on the way up may end up fueling the collapse on the way down. Here's why. On Friday, Jan. 29, GameStop stock closed at $325 per share. According to data from Nasdaq.com, the following expiring near-the-money yet still in-the-money call options look like they were still open at the market close:

  • 7,835 contracts at $320 per share.
  • 855 contracts at $310 per share.
  • 1,170 contracts at $300 per share.

When options expire in the money, brokers typically automatically exercise those options on behalf of their clients. And that's where the risk starts. Once exercised every one of those options contracts require the holder to buy 100 shares of stock at the options exercise price. Those three options contracts alone are forcing people to buy 986,000 shares of GameStop stock  over this weekend, for a total out of pocket investment of $312,325,000.

Man looking sad at his wallet while money flies out of it.

Image source: Getty Images

For a sense of scale, one single contract at $320 requires an investor to pony up $32,000 to buy the shares at expiration. At some point between market close on Friday Jan. 29 and market open on Monday Feb. 1, affected former GameStop options investors will wake up to find they are now GameStop shareholders. Not only are they now shareholders, but they are out tens of thousands or hundreds of thousands of dollars or more.

If those investors don't have the cash or margin buying power to complete the purchase, their brokers will issue a margin call and forcibly close out those positions by selling GameStop stock. Just as buying the stock and options forced the short squeeze and gamma squeeze on the way up, mandatory, broker-initiated selling resulting from margin calls could force the process to reverse.

When a broker forces a sale because of a margin call, that broker does not care what the price of the underlying asset is. All that broker cares about is getting the account within regulatory or contractual limits. This is a strong and structural mechanic of why short and gamma squeezes are such dangerous, double-edged swords that can reverse just as easily and quickly as they form.

Even if these newly minted GameStop investors aren't forced out of their positions because of a margin call, many of them may decide to sell anyway. After all, it is one thing to gamble a few hundred dollars on an option, but it's something else entirely to find yourself committed to tens of thousands of dollars (or more) in a very speculative stock position.

Beware the cult of personality

Beyond the structural mechanics of short and gamma squeezes, GameStop investors face another, more personality-driven risk. At the center of the mania is a single Reddit poster (whose online username can't be reprinted in a family friendly publication), who has regularly posted his investment progress on the stock.

The risk doesn't come so much from his postings, which have largely consisted of just screen captures of his brokerage account positions and value, but rather the mass of those who have followed him. The community comments in response to his posts are littered with sayings like "if he's still in, I'm still in" and all sorts of references to "sticking it to the man." Those are not the sayings of rational, valuation-focused investors, but rather people swept up in an emotional movement or commitment to a person.

Emotional investing may work for a little while, but it rarely ends well. First, those that have followed along by buying up all those call options that caused the gamma squeeze may not have fully recognized the financial commitments they made by buying those options. Their fanatical commitment may quickly wane once they realize just how deep into it their own pockets they have really reached to take part in this movement.

Even if that doesn't cause the stock to come tumbling down, at some point, the Reddit poster is going to decide he has gained enough wealth from that particular speculation and reduce or close his position. His position -- 50,000 shares and options to buy another 50,000 more  -- is only a small fraction of the daily volume on the stock and may not be enough to move the market on its own. When he sells, however, all the "if he's still in, I'm still in" investors will probably rush to sell as well.

With the leader out and the mass of followers not far behind, what's left to hold up the stock or keep those short and gamma squeezes from rapidly reversing? Even worse for those following along, many of those holding only because the original poster is still holding will find out the hard way just how quickly the market can turn the other way. Paper profits can quickly turn to very real losses, especially when the drivers of the initial move in one direction become the drivers of the move in the opposite direction.

It's not a question of whether, but rather when

Short squeezes and gamma squeezes eventually run out of steam. Whether it's because of the mechanics of expiring options, the person at the eye of the storm deciding he has profited enough, or some other reason, the GameStop momentum will also run out.

Investors who are holding because they think they will really make money from the trend continuing risk being the poster children of falling victim to the greater-fool theory. They run the very risk of losing everything they've invested -- or even more, if margin is involved.

If you are an investor in GameStop stock or options, consider the very real and incredible risks you are facing and plan and act accordingly. This party is very likely to not end well, and those who are the most euphoric now may very well end up hurt the worst when it does end.

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