Ranjan here. This week I am going to try to explain a Gamma meltup to the non-finance folks while digging into what happened to the markets this summer.
Masayoshi Son, at one time considered to be the Warren Buffett of Japan, has pretty much gone full Robinhood trader. - Bloomberg
In that Doordash piece, I mentioned how I get Softbank-triggered whenever I watched a Vision-Fund’ed company "raise a ton of money, lose a ton of money, and just obliterate the basic economics of an industry." I've also wrote how I get Robinhood-triggered when I watch newbies dive into options trading and distort markets while endangering their bank accounts. In my most recent post, I wondered what the hell was driving the insane summer moves in the stock market.
Never, in a million years, could I have imagined that all three of those posts would come together in some magical end of summer confluence. That summer rally. That 26% Salesforce ($CRM) move. That 45% Zoom ($ZM) move. Those Apple and Tesla split rallies.
One of the reasons I’ve effectively been ignoring markets is that it was so obvious there was something very artificial about what was happening. Especially having worked in emerging markets trading, where markets are illiquid and specific trading flows can move markets, you can feel when things are being driven by “trading” and not “investing”.
There was plenty of speculation over whether Robinhood and retail traders were pushing the market. But never, ever, in my wildest dreams could I have imagined that my favorite spoil Softbank had themselves gone full Robinhood! Never could I have imagined that the same people that made pizza delivery weird were making the S&P 500 weird.
2020, just stop it. This is getting too ridiculous. Nothing is real. Nothing makes sense. I have reached some sort of Margins singularity. I am laughing like a crazy person at my desk.
I feel like this robot (image via Insider)
Okay, I'm going to try to get a hold of myself and explain what happened. Because the more I thought about it, it all makes complete, perfect sense. If this does turn out to be a final act of sorts for this mad market, the writers will have truly delivered a masterful crescendo.
RAJEEV
Let's go back to 2017. I still remember when I first learned that the head of Softbank's Vision Fund was going to be an ex-Deutsche Bank credit derivatives trader. As someone from the bank trading world, I found it a bit odd. The moment I arrived at business school, I quickly realized that trading provided very few transferable skills relevant to the business world. You don’t even quite learn to invest, so much as financialize things (I’m not saying that’s a bad thing, just different). From what I understood, Rajeev had been involved in structured financial products, which are the opposite of understanding operational capacities and market sizes.
I spoke with someone in 2018 who had pitched the Vision Fund, and he relayed what would become an almost cliched story: They were trying to raise $100 million and were asked what they would do with $500 million. When they pushed back, they were told that if they didn't take the $500mm, it would go to their closest competitor and they would be crushed. It sounded really weird to effectively threaten a founder with more money than they had a plan for, but we all came to learn this was some new kind of investing that would play out most famously, or at least, publicly, with WeWork and the whole "you need to be crazier, Adam" story.
But you definitely started to see the Deutsche trading floor spirit of complex structured finance making its way into the way Softbank did private markets. Just go back to that famous Series H WeWork round that supposedly valued WeWork at $47 billion. The big announcement was that Softbank invested $2 billion at a $47 billion valuation, yet $1 billion of that money was going to buy shares from investors and employees at a valuation of $20 billion.
At the exact same time. Like some kind of weird Schrodinger's valuation.
That is the type of financial innovation that would make a bank trader proud.
GAMMA
Which brings us back to the current state of the markets. This summer has been nuts. It was so clear that something was completely off. It just got more and more nuts. Salesforce, now a $200 billion company, had a +26% move. Yes, they are positioned well for the post-COVID economy blah blah, but those moves just don’t happen at that size. Zoom, after a solid earnings report, was up freaking 40%. Again, Zoom is a great company and the future blah blah blah, but a +40% intraday for a company of that size must’ve been turning analysts armed with only DCF models into crazy people hurling feces from the corner of a room.
And then, Zerohedge first, then the FT and the WSJ, reported that, yes, Softbank was at work. They were buying up call options.
I had read that Softbank had started investing in all the trendy public tech companies. It brought a smile to my face; that after all the unicorn charts and 300-year plans...they just were mimicking every single other investor. But a few billion dollars spread across the stocks of a bunch of trillion-dollar firms could not be what was really tweaking the markets. But $4 billion poured into relatively illiquid options markets could. This week we learned what Masa and the Deutsche crew were up to, and if the Schrodinger's WeWork valuation was the appetizer, this is really the main course.
Okay, I'm going to try to explain to you the concept of a Gamma meltup. It might be a bit ambitious to explain all of this in a newsletter, but these are all genuinely straightforward concepts and anyone with any investments should at least try to understand what’s at work.
$MRGN
Let's say my co-host Can and me have taken Margins public (maybe via a reverse merger with the Mergence Corp to get the ticker $MRGN). $MRGN stock is now worth $10, because this free newsletter is such a great business.
Robin H. the investor thinks MRGN will go up a lot and very soon. But instead of buying the stock itself, she buys a call option - which is the right to buy the stock at a given price on a set date.
- Robin buys call with a strike price of 20 that expires on October 16th, 2020 for $1.
- If on October 16th MRGN is trading at $30, that contract/option is now worth $10 and happy days, Robin H. has made $9.
Where things get interesting is Robin had to buy that option from someone. Enter the market maker who we'll call Ditacel.
- When the market-maker 'writes' the option and sells it to Robin they make $1 upfront. They now have the obligation to sell MRGN to Robin at 20 on Oct 16th.
- But if our MRGN stock goes up to $30 when that option expires, they have now effectively lost $9.
- If free newsletters get even hotter and MRGN is at $100, Ditacel after taking $1 upfront to sell that option to Robin, has lost $80.
Again, Robin has the right to buy at a certain price while Ditacel has the obligation to sell at that price.
The most important dynamic to understand is the people selling the call options have theoretically infinite losses.
The sellers of options need to hedge or cancel out all that risk. You can buy the underlying stock - that way if the stock runs up, you would lose money on the option you sold but make money on the stock you now own. You can buy a similar call option from some other market-marker. Both of these hedging actions would exert some kind of upward pressure on both the stock and the call option price.
This act of hedging your risk from selling options is known as managing your Gamma. According to Goldman back in June, "Gamma has the potential to be one of the most important non-fundamental flows in equity markets".
It's exactly that - a flow of money that has nothing to do with the fundamentals of companies or economies but is simply a weird momentum byproduct of options trading.
In a normal market, this risk-hedging wouldn't have any real impact on the price of the stock itself. The amount of options being traded would be tiny relative to the amount of actual stock being traded. All this stuff would be taking place via transactions triggered in the background by automated risk systems and we would instead be analyzing earnings reports to assign long-term valuations.
There had, however, been talk of a secret "Nasdaq whale" that was buying up billions of dollars in call options, and this week we found out it was motherfucking Masa, man!
Now it has also made a splash in trading derivatives linked to some of those new investments, which has shocked market veterans. “These are some of the biggest trades I’ve seen in 20 years of doing this,” said one derivatives-focused US hedge fund manager. “The flow is huge."
and we also need to factor in that normally during the summer, trading volumes are lighter, making any big trade have even more of an impact:
The size and aggressiveness of the mysterious call buyer, coupled with the summer trading lull, has been a big factor in the buoyant performance of many big tech names as well as the broader US stock market, according to Mr McElligott. This week, he warned that dynamics around options meant the heavy purchases forced banks on the other side of the trades to hedge themselves by buying stocks, in a “classic ‘tail wags the dog’ feedback loop”.
UPWARD SPIRALS
Try to understand the self-reinforcing aspects of a strategy like as follows:
SoftBank buys far more call options than the market is used to handling. The market-makers have now sold far more call options than they're used to and need to hedge, meaning they're going to be buying that underlying stock. That pushes the price up, meaning they will need to buy even more of that stock to hedge. And let's not forget the COVID + software will eat the world stories, which are very true. Does anyone want to bet against Apple or Tesla or Amazon or Zoom or Shopify? What other stock are you going to buy?
This explains how a giant company like Zoom goes up 40% in just one day. There's natural buying pressure from people excited about those amazing earnings, but these distorted market dynamics create a buying frenzy as the market-makers who are exposed to these run-ups have to buy more and more of the stock to keep their exposure down. They buy more stock to hedge which triggers algorithms somewhere else to buy more of that stock. Regular humans who just want to buy stocks get alerts about an amazing stock and also buy that stock. Which makes the market-maker who originally sold the option need to buy even more stock to hedge. That's the Gamma Melt-up.
A good thread that outlines some numbers behind a potential Gamma melt-up
Suddenly Softbank is showing profits of $4 billion in just two months on an initial investment of $4 billion (a 6300% IRR?)!
To anyone from outside of finance, it must sound ridiculous that this is how the very capital markets that handle your retirement money function, and as I write it, it kind of is. But again, if there's one thing to take away, it's that there can be these quirky, short-term feedback loops (reflexivity in real-time!) that completely distort prices in a market.
And if there's one thing I always would've imagined the Softbank investment team was genuinely qualified to do, it's this kind of stuff. Investing in data-driven dog-walking apps always felt a bit out of their wheelhouse. Exploiting the short-term dynamics of a somewhat illiquid, fast-moving and gigantic market? That’s the stuff Deutsche traders crave for. Rajeev Misra oversaw the Deutsche traders who made the bet against U.S. subprime and were even featured in The Big Short. Meanwhile, the new head of the Softbank public markets fund behind all of this was formerly a prop trader at Deutsche.
Maybe the world is finally making more sense to me.
CONCLUSION
It's not just Softbank either. There's plenty of debate over whether the options activity of retail traders as a whole has been affecting the market. Whoever is "to blame" the Robinhood-ification of the stock market as a whole has already taken place:
Goldman had observed a "historic inversion" in the stock market: for the first time ever, the average daily value of options traded has exceeded shares, with July single stock options volumes hitting 114% of shares volumes.
In most matters of capital, there is always some element of a game. But there is also that whole capitalism thing where capital is smartly allocated to create businesses. When Softbank is involved, it feels like the entire thing becomes the game. It's all financial engineering, and of course it is! That's who was always running the show!
Hopefully, the above explanation made some sense, especially for the non-finance folks. The gamification of the public equity market has been fun for me to watch and has certainly made a lot of people who have actually managed to sell a lot of money. But, while it's boring, it's worth remembering that capital markets are supposed to be about allocating capital. And there are real consequences to this run-up. And when we have record highs in the stock market like this, things happen, like we collectively lose the will to push through an extension to the stimulus.....
Note 1: This self-reinforcing Gamma melt-up is not a secret. r/WallStreetBets was supposedly coordinating similar strategies on small-cap stocks. I know this post is already really long, but I wanted to paste this entire section from Matt Levine’s newsletter because it's from all the way back in February, yet reads so perfectly when switching out r/WSB with Softbank:
Another big part of the r/WSB story is about, uh, manipulation? I do not want to give you legal advice, but as a general matter, for entertainment purposes only, I will say:If you like a stock, and buy it, and go post on Reddit “I like this stock and bought it and here is why,” and other people are persuaded by your reasoning and buy it too, pushing the stock price up, then good for you, smart trade.If you like a stock, and buy it, and go post on Reddit “wouldn’t it be funny if we all buy this stock to push the price higher and then offload it to unsuspecting n00bs who are attracted by the price action,” and your Reddit buddies are persuaded and you all go and do that, then that might be market manipulation.If you buy a stock and go post a bunch of lies on Reddit about how great the company is and how it has discovered a cure for cancer that will be announced imminently, and other people read your lies and are persuaded and buy the stock while you sell it, then that might be securities fraud.And one natural result of r/WSB’s effect on the market, and of the attention it gets from the media (sorry!), is that more posts on the forum will tend to be in categories 2 and 3, because now those categories can work. You need an audience for manipulation, and now you can get one. Byrne Hobart notes that an audience for manipulation might attract professional manipulators; “in equities, the scalable professionals are either a) people who work in the industry and are constrained in how much they can tout, and b) criminals.”
Note 2: These kinds of self-reinforcing strategies have always been present in smaller, more illiquid markets. The gamesmanship in the Trading Places attempt at cornering the orange juice market is still one of my favorite movie scenes of all time. Sell Mortimer!
Note 3: While all the main financial publications are doing great reporting on this story, ZeroHedge really has been a must-read. When it comes to financial skullduggery and complex market dynamics, and especially anything Deutsche related, they're still a go-to.
Note 4: I have never written/sold options and only understand the concept of Gamma hedging at a theoretical level. I’m sure there will be some who read this and think “this guy has no clue”. This was a good thread from someone who insists that Softbank hasn’t really had an effect:
Note 5: Where do we go from here? While these newsletters by no means constitute investment advice 😀 (seriously, remember my rule: "a general rule is anytime anyone tells you about an investment, you shouldn't listen.") I will say that I have been flummoxed and frustrated at how little sense the markets were making to me. Suddenly, things make just a little bit of sense.