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I finally figured out the actual financial instrument strategies responsible for the unprecedented rise in “meme stocks”, such as AMC and Game Stop. Their increases in price, each of more than 1000%, were not normal short squeeze behavior. A run-of-the-mill short squeeze will typically go up maybe 50% or so. These stocks went up thousands of percent. It was unprecedented behavior that I have never seen in my 21-years of professional Wall Street investing.
I recently did in-depth research into ways to bet on Moderna stock going down without actually shorting it (the current environment is unsafe to short anything). I looked at selling call options, and then I realized happened with the meme stocks.
Basically, daytraders like to sell options because they think it is easy instant money. But they do not realize that, if the trade goes wrong, they are suddenly on the hook for many times more than what they raised in revenue by selling the option (With Moderna, for example, I could have owed $9 Million if the trade had gone wrong, and I would have made only $100,000 if it had worked. Losses are highly leveraged.).
Normally, this type of high-risk speculation is not allowed because there are federal regulations requiring broker-dealers to have certain margin requirements. However, what changed the game was when Robinhood broke the laws and was giving daytraders 1000% leverage. It costs too much money to buy an insurance call option in addition to selling a call option. So, daytraders were selling naked options without any insurance policies. Therefore, thousands of daytraders, encouraged by Robinhood (and Citadel), were buying call options on these meme stocks (even though they thought the stock would go up a little, but not as much as the stocks actually did). Not only were the hedge funds covering their shorts when the stocks spiked, but then daytraders had to be on the hook for the underlying stocks in those options that they sold (i.e., the dollar amount above the strike price of the naked-call option they borrowed and sold).
In addition, large hedge funds were essentially shorting the meme stocks by also selling call option, because regular shares were no longer available (also without purchasing expensive insurance policies). They thought that, since AMC and GameStop should go to zero, it was a safe bet to sell naked call options.
Now, I put this all together using common sense and the fact that I have not spotted any of this stock behavior before. However, no one in high levels of Wall Street whom I have asked over the last eight-months has seemed to spot this as even curious. They do this for a living at high levels in Wall Street did not have the energy to ask questions, apparently. It did not occur to these dimwits to ask themselves why they have never seen this behavior before and realize it was a unique phenomenon (Just as no one asked questions about CDO’s going into 2008)?
It reminds me a lot of people who work at car dealerships. Walk into even a high-end Mercedes dealership and ask the sales person how to use the electronics inside the car. They won’t have a clue. They sit there all day long and do not have any inquisitiveness or desire to learn how to use the products they sell.
One other thing: Big hedge funds were allowed to sell these call options because the broker dealers were also breaking rules on margin requirements and covering it up, I highly suspect (stay tuned). This is why we are going to have another financial collapse. Broker dealers got in way over their heads by loosening the rules. It is a big stinking rotten whale carcass that has not washed ashore yet (I do not know exactly what is wrong there. I just highly suspect that balance sheets are hiding large obligations they cannot pay. The failure of Archegos was the first of many to fall, and the broker-dealers that loaned them the trades are sitting on some foul things.).
The bottom line is that derivatives are what fueled these multi-thousand-percent spikes this time. Derivatives are what caused the 2008 collapse too. They are weapons of mass destruction, as Warren Buffett calls them, and yet the federal agencies still refuse to regulate them in the same way that actual stock markets are regulated. Wall Street makes too much money selling options.
PS: Maybe my Wall Street friends are not as stupid as I think. They could just be in denial. Everybody looked the other way before 2000 and 2008 too.