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How the Internet Sent GameStop Stock Up 1,000% — And Where It’s Going Next

In December, I wrote an article suggesting investors write covered calls on GameStop (NYSE:GME): buy GME stock and profit from the fat premiums on call options. It’s a conservative tech investor’s way of making money on a stock that’s too hot to buy, but too strong to ignore.

Retailers walk past a GameStop (GME) store in New York City, New York.
Source: Northfoto / Shutterstock.com

Investors following that strategy would have seen a 25% gain in three weeks — not bad for an options strategy with capped upside. But with shares now up 1,000% since last year, people are starting to ask themselves: “How did we get here in the first place?” The answer is a complicated mix of finance, momentum and a virtual game of chicken. So, here’s how we got to where we are, and where GME stock might head next.

GME Stock: Back From the Dead

In a year where both Microsoft’s (NASDAQ:MSFT) Xbox and Sony’s (NYSE:SNE) PlayStation finally released digital-only versions of their consoles, you might think that GameStop stock investors would have panicked. For years, the company had resisted calls to modernize. Instead, the brick-and-mortar relic stayed alive thanks to its cash cow: the lucrative used-game market. And now that many next-generation game consoles will no longer need physical games, GME stock looked set to fall.

GameStop shares, however, did precisely the opposite of what you might expect. Proving that no amount of wisdom can predict the madness of crowds (or internet users), shares rose 150% by the time I suggested taking gains off the table. Since then, the stock has proceeded to triple.

Why Is GME Stock Up 1,000%?

Long-term investors with a sense of humor might remember the Financial Times suggesting that the then-dying RadioShack could start selling fruit baskets or turning stores into Zumba studios to survive. (A small town in Weaverville, CA seems to have done just that.) That’s because, in the world of brick-and-mortar retail, those that don’t adapt end up like Blockbuster and Circuit City — sitting in bankruptcy court and explaining lawyer fees to angry investors.

For years, GameStop seemed destined for the same scrapheap. Though management successfully lobbied Microsoft in 2013 to keep disc drives in the Xbox One, they failed to use that lifeline to migrate toward online and mobile games.

But don’t discount the short-term.

The release of the blockbuster PlayStation 5 and Xbox Series X threw Wall Street’s tea leaves into disarray. With both consoles selling out within minutes, analysts scrambled to revise GameStop’s estimates for the near term. Wall Street now expects sales to rise 4.5% this quarter, representing a reversal after years of decline. And bullish retail investors went wild, sending the stock from the $4 range to $14.

The Internet Spins GME Stock Out of Control

But retail investors weren’t done quite yet. By December, a strange phenomenon started to appear: Open interest in GME calls had reached unprecedented levels as online investors egged each other on. In other words, investors were not only betting GME stock would go up but also that gains would come sooner rather than later. And whenever this happens, investors can inadvertently start a feedback loop. That’s because buying call options en-masse also force market makers to buy the underlying security — in this case, GME shares. It’s a process known as delta hedging, where market makers like the New York Stock Exchange look to keep a neutral position.

Meanwhile, rising share prices force short sellers out of their positions, causing them to become buyers in what’s known as a “short squeeze.” That forces up shares even further, causing even more online users to (self-reportedly) buy in, and so on. Eventually, the company’s shares end up as a caricature of its intended price.

And how long can the mania go? A) If someone’s had the misfortune of going short, the feedback loop will usually continue just long enough to force them out of their position at a loss. B) If they’re long, the loop will last just long enough to when they’ve convinced themselves that the stock is a long-term winner. And C) if they don’t own the stock and decide to buy in, that’s usually the precise moment that the bottom falls out.

Lessons From GNC

It’s not the first time a brick-and-mortar store caused such an investor frenzy. Almost a decade ago, GNC found itself in the eye of the protein-supplement storm. What was once the purview of bodybuilders suddenly saw its 15-minutes of fame. Pantries across the U.S. stocked up on the protein “miracle cure” for everything from weight loss to muscle building, and GNC’s stock rose from $15 in 2012 to almost $60 by the end of 2013.

Back then, however, options trading was far more limited. Robinhood was only just getting started, and most retail investors didn’t have the tools needed to send market makers and short sellers into an upward-spiraling feedback loop. Even as bearish short interest in GNC stock mounted, short squeezes rarely amounted to more than 20% price jumps.

GameStop, on the other hand, makes GNC look like child’s play. Today, GameStop has a 109% short interest ratio, meaning there are more shares sold short than exist.

And GME’s open interest of nearly 850,000 options is seven times greater than Best Buy’s (NYSE:BBY) 115,000, even though GME is less than a tenth of the latter company’s size. While Citron Research’s $20 price target for GameStop could be right, there’s nothing that can stop retail investors pushing GME to $60 and beyond in the short term. There simply aren’t enough shares to sell short.

What’s Next for GME Stock?

It’s impossible to know how far GME can rise from here. The company now trades for 373 times its Shiller price-to-earnings (P/E) ratio, a measure of long-term value. Today, shares are looking less like Best Buy’s steady-state 36x multiple and more like Amazon’s (NASDAQ:AMZN) high-growth 355x.

So, when your company’s share value isn’t attached to real life, what’s to stop it from rising to 600 times or more? The 17th-century Dutch-tulip-bulb mania offers a sobering reminder of humanity’s ability to ignore reality. At their peak, the most expensive bulbs could cost more than a house.

Those insisting to profit from GME should consider selling options and hedging with a position in the underlying security — much like what professional market makers do. With implied volatility close to 180%, GME options are selling for fat margins; at-the-money 2022 calls cost almost $16.

But don’t go naked short or long GameStop and expect easy wins. As we collectively stumble through 2021, it would be wise to remember this: GME stock could continue a run to $60 and beyond if the short squeeze (and internet cheerleaders) continue their gleeful mischief.

But unless GameStop management uses the momentum to revamp its business, it would all be for nothing. Because, as hundreds of defunct brick-and-mortar companies can attest, if you won’t stop yourself from pursuing an outdated business model, then a bankruptcy court will eventually do it for you.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.


Article printed from InvestorPlace Media, https://investorplace.com/2021/01/how-the-internet-sent-gme-stock-up-1000-and-where-its-going-next/.

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