The meteoric rise in the price of GameStop shares in January had many investors and media outlets riveted. How could a group of small investors muster the capital to force share prices up 20-fold?
Two professors at the Leeds School of Business at CU Boulder present a theory that suggests how that happened in their research paper titled “The sky’s the limit: Asset prices can be indeterminate when margin traders are all in.”
Their theory asks the questions: Why GameStop? Why January 2021?
Some investors are all-in, meaning that they buy as much of the asset as they can afford and use all available leverage to do so. When enough investors are all-in, the price of the asset becomes unstable. An increase in the price of the asset increases the value of all-in investors’ positions and they borrow against this value to buy more shares.
A higher price normally reduces demand, dampening price volatility. When enough investors are all-in, demand increases as the price increases, generating a possibly endless price spiral. This instability requires all-in investors to have a substantial number of shares and requires them to be able to leverage their money more than 2-to-1. This can take place only if they have the ability to purchase stock options, which allow investors to buy and sell shares at a specific price on a particular date.
An example of that behavior would be a trader who has $10,000 cash in her brokerage account and then uses a further $10,000 of leverage provided by the brokerage to purchase $20,000 worth of stock. If the price doubles, she will borrow against the $20,000 profit to buy more stock, increasing the value of her position to $60,000, $30,000 of which is debt. If she has access to stock options, then her effective leverage might be as high as 4-to-1 or 5-to-1.
This theory differs from the prevailing theory of GameStop’s rise, the professors said. The standard view is that retail trader demand caused a short squeeze, which happens when short sellers who are betting that a stock’s price will drop borrow the shares of stock and sell them. When the price of the underlying stock rises against their expectations, some short sellers are forced to repurchase those shares to cut their losses.
This is the “squeeze.” Demand from retail investors begets demand from short sellers. In both the traditional situation of a short squeeze and in the new theory written by Van Wesep and Waters, higher prices cause an increase in demand and therefore cause even higher prices. The difference is that in a short squeeze, when the short sellers have closed their positions, prices have no further upward pressure whereas when investors are all -in, there is always pressure for prices to rise, regardless of how high they go. Which theory is right?
“If causing prices to skyrocket by buying shares and precipitating a short squeeze is that easy, it should be happening all the time,” Van Wesep said. “It would be easy money for any hedge fund that wanted it. But it doesn’t. That struck me as worth investigating. What we saw with GameStop was a very fast price spiral.
We saw it again on February 25, when there was no short squeeze.
“How do you get price spirals? Upward-sloping demand is the key. You need something that causes people to want to buy more when the price is higher. Why would that happen? Well, it so happens that when I was a student in my 20s, I was an all-in investor and made and lost a lot of money trading stock options, so I had some familiarity with the behavior that we’re seeing from these Robinhood traders.”
Regarding GameStop, Van Wesep thinks what changed is that Robinhood and maybe other brokers gave regular traders instant and easy access to margin accounts and option trading accounts.
“You get a margin account, which allows you to borrow to buy shares or trade stock options,” Van Wesep said, “which are in part another way to lever up your position. You can make a lot or lose all of your money very, very fast. Prior to Robinhood, brokers would only give margin and option access only to sophisticated investors who aren’t likely to be all- in.”
The question that Van Wesep and Waters wanted to ask is: What are the consequences of that access to leverage, of borrowing to buy? They found is that it’s possible now to get the type of price behavior seen with GameStop. The price instability that Van Wesep and Waters find requires that all-in investors have access to leverage beyond the 2-to-1 limit that is the legal maximum in the U.S.
“But with stock options investors can lever much more than 2-to-1,” Waters said. “It’s giving this type of investor access to options trading that allows this behavior to be possible. One interesting thing is that we didn’t expect this to happen when we wrote the model. However, if you allow people to have more than 2-to-1 leverage, that’s the precise amount that can lead to out-of-control prices.”
Van Wesep and Waters have long been interested in how market dynamics affect financial behavior.
Van Wesep earned a bachelor’s degree in applied mathematics from Brown University in 2003 and a doctorate in economics from Stanford University in 2007.
His research spans several areas of economics, including asset pricing, contract design, employee compensation, and microeconomic theory. He teaches graduate-level economics courses in the Leeds MBA, evening MBA, masters in finance and masters in real estate programs.
Waters is an assistant professor of finance. He teaches investment and portfolio management at the undergraduate level and teaches a graduate-level course in financial theory. He earned a doctorate in finance from the UCLA Anderson School of Management, and bachelor’s degrees in economics and in human and organizational development from Vanderbilt University. His research interests include corporate finance and microeconomic theory with a focus on the design of incentive and screening contracts. His other interests include information theory and asset pricing.
It is important to note that Waters and Van Wesep’s paper proposes a theory regarding GameStop’s price behavior. More research will be needed to determine the accuracy of the hypothesis.
“What we show in the paper is that one consequence of allowing retail investors to lever up is that you can get rapid price increases like we saw in GameStop,” Waters said.