Could Retail Investors Cause the Next Crash?

While much has been said about the turmoil caused by retail investors bidding up the stocks of companies like GameStop and AMC Entertainment (-20.96%), less has been mentioned about their potential to wreak havoc in the other direction.

Short sellers are an “easy enemy” to coalesce around, they bet against a company succeeding when everyone would prefer a story about a hero and a grassroots-led initiative to “punish” these pessimists ought to find no shortage of supporters.

But what if the Redditors themselves became the ones to short companies?

Retail-centric trading apps like Robinhood have made going short just as easy as going long, with share options trading a remarkably painless process.

And while Redditors have a natural preference for long positions, bearish put options were laid on just as shares of GameStop came crashing down, many of which were retail positions.

Given that the markets contain plenty of froth right now, put options (the right to sell at a specified price) have the potential to cause much greater damage to the downside. When a trader buys a bullish call (the right to buy at a certain price – the “strike price”), the market maker who sold the contract will typically hedge by purchasing the underlying stock.

The more the stock rises toward the option’s strike price, the more shares the market maker will have to buy and that can supercharge stock prices as shares rise and market makers are forced to buy more to hedge their exposure.

But the dynamic, known as “gamma squeeze” (because why not give it a fancy name?), works in reverse as well.

Market makers who have sold bearish put options need to hedge themselves by selling the underlying shares.

And as the price of the share falls towards the option’s strike price, market makers will be forced to sell more shares which will cause the price to drop further.

That self-perpetuating feedback loop is what has some investors concerned that the next market crash may be caused by retail investors.

Because if the bearish put options are placed on say overvalued tech stocks that are components of key indices like the S&P 500 or the Nasdaq Composite, that could cause a market panic.

And it doesn’t help that tech stocks are already at frothy valuations, providing plenty of room for a narrative that they are overvalued that could plunge the market into despondency.

But any putsch of such tech stocks is likely to be short-lived, because unlike GameStop and shares of such other unloved companies, the stocks of tech giants are highly liquid and make up the portfolios of countless pension funds and other institutional investors.

That’s not to say that a crash couldn’t happen – it absolutely could, but it won’t be durable – the same way that the rally in GameStop share’s wasn’t permanent, or the invasion of the Capitol building by Trump supporters did not lead to another American Civil War.

As it is, market makers are short on puts (the right to sell) because persistent bullish demand has made them overweight on call options and buying up stocks to hedge.

And successive waves of selling could lead to market turmoil that has the danger to see big corrections, with the cascading effect (like dominoes, but more deadly) leading to an entire market collapse.