GameStop Frenzy Forces a Look at Zero-Fee Options
Pedestrians walk past a GameStop Corp. store in Rome, Italy. (Photographer: Alessia Pierdomenico/Bloomberg)

GameStop Frenzy Forces a Look at Zero-Fee Options

Perhaps the most remarkable part of the stunning, Reddit-fueled surge in shares of GameStop Corp. and other companies is just how powerless the top U.S. regulatory bodies are to do anything about it.

The past week has shown that a group of individual investors banding together can drive up the price of specific stocks, most notably heavily shorted companies like GameStop and AMC Entertainment Holdings Inc. At first, Federal Reserve Chair Jerome Powell simply dismissed this phenomenon, noting in his press conference Wednesday that “I don’t want to comment on a particular company or day’s market activity.” When pressed about whether he and other officials would consider adjusting Regulation T, which sets initial margin requirements, he seemed outright irritated, saying point-blank it wasn’t something they were thinking about “at all.”

It’s not as far-fetched a question as Powell made it seem. Bloomberg’s Cameron Crise wrote about Regulation T before the Fed decision, noting that the initial margin requirement of 50% has been left unchanged since 1974. That is to say, when the internet was still an experiment, there was no such thing as a Bloomberg terminal, the S&P 500 Index traded in the double digits and 10-year Treasuries yielded 7% to 8%. So much has changed in the past decade, let alone half-century, when it comes to accessing financial markets that it’s rather odd that this tool has been entirely untouched.

While the GameStop story (or what some are calling a “revolution”) is still being written, one of the obvious reasons this kind of retail-driven rampage can happen in today’s markets is the rise of zero-fee options trading at many brokerages. This race to the bottom was inevitable, and, much like the fee war among mutual funds and exchange-traded funds, no-cost trading is certainly a boon to everyday investors who want to sock away a bit of money in low-cost ETFs that track broad indexes.

It’s an entirely different ballgame when options are involved. As Bloomberg News’s Katherine Greifeld reported recently, options traders who buy or sell 10 or fewer contracts at a time have been on a shopping spree, adding almost 60 million call options in the last three weeks. That’s 20% more than in the late summer of 2020, when they drove shares of the so-called FAANG technology companies to records. The feedback loop of huge purchases of call options has been well-established at this point: Market makers that sell the calls need to hedge their position by buying shares, which can help drive the price of the stock higher, which increases the value of the calls, which requires further share purchases from dealers, and so on. If the companies happen to be heavily shorted, like GameStop and other popular names as of late, the prospect of short-covering only adds rocket fuel to wagers that prices are going “to the moon.”

Which brings me back to the Fed. For months now, I’ve been writing that negative real yields are here to stay in the U.S. and that central bank officials will have no problem with that, regardless of the financial-market distortions it might bring. When I brought up that thesis during an interview with John Hollyer, head of fixed income at Vanguard Group Inc., he agreed, though noted “you could have valuation risks that are in some ways financial stability concerns — you could have asset bubbles in equities or other risky assets.”

To remedy that, he said, “it could be that if they feel the need to sustain the financial repression for further years, that they’ll use other macro-prudential regulation that might limit borrowing or leverage in certain sectors of the economy to try to manage those bubble risks.”

Our discussion, mind you, was well before Reddit’s WallStreetBets forum became the talk of the financial world. Now, the feeling that something has to be done is growing among the professional financial class. “What is going on now — there should be legal and regulatory repercussions. This is unnatural, insane, and dangerous,” Michael Burry of “The Big Short” fame tweeted on Tuesday. 

Leave aside for the moment the counterargument that hedge funds overseeing billions of dollars don’t need protection from individuals buying options for laughs on an online forum. Assume that this is more than just a flash in the pan, and central bankers and regulators find that share prices entirely detached from company fundamentals are a problem and that Treasury Secretary Janet Yellen truly is “monitoring the situation.” What can be done?

Regulation T would be a good place to start, even though it sounds extremely unlikely to be considered anytime soon. With the Covid-19 pandemic still raging, Powell and his colleagues are content to let real estate and equity prices soar higher to keep overall confidence up. But once past the virus, the central bank could theoretically ratchet margin levels higher at its discretion. 

Scott Minerd, chief investment officer with Guggenheim Investments, said on Bloomberg TV after the Fed’s decision that he’s always been in favor of a more aggressive use of Regulation T. “I would think it would be prudent at this point for the Federal Reserve to raise margin requirements modestly in order to try to damp down some of this frothiness,” he said. “The problem, of course, is I’m not sure how far the horse is out of the barn here. Because if we were to increase margin requirements from, lets say, 50% to 75%, perhaps that’s enough to break the back of the market.”

To get a sense of how this would work, the U.S. Securities and Exchange Commission has a hypothetical example on its website (notably, from 2009), which I’ll adjust for GameStop trading.

Let’s say you bought 100 shares of GameStop at $140 when they were surging at 10:39 a.m. on Monday. That $14,000 purchase could be split between borrowing $7,000 from the brokerage on margin and paying $7,000 yourself, thanks to the initial margin requirement of 50%. But by 12:09 p.m., the price had dropped 33% to $93 a share. With a market value of $9,300, your equity position is $2,300, which is just below the current 25% minimum maintenance requirement. You are subject to a margin call and must either deposit more cash or risk the brokerage selling your shares until you’re above the minimum.

If Regulation T set initial margin at 70%, then a person who had $7,000 to invest could buy only 71 GameStop shares at $140, rather than 100. This clearly creates friction at first. But if maintenance requirements stay the same, it also helps fend off margin calls — at $93 a share, the market value of this stake would fall to about $6,600, but because the broker only put up $3,000, there’s still more than enough equity.

What this doesn’t do, of course, is much of anything to directly influence options trading. Again, there’s a groundswell of people who are buying just a handful of calls at a time. That is probably not happening with margin — the options themselves, after all, are a leveraged bet at a lower up-front cost. And just about everyone seems to be buying into this frenzy with eyes wide open of the risks and rewards. As my Bloomberg Opinion colleague Matt Levine has pointed out, that makes it difficult for the SEC to claim market manipulation or securities fraud: “Seems like the sort of thing the SEC wouldn’t like. But what can they do about it?” he concluded.

Put together, it’s hard to see how regulators could close the Pandora’s Box of no-fee options trading. The only way to slow this down, it seems, is for the online trading platforms to step in themselves. On Thursday morning, Interactive Brokers Group Inc. said that options trading in GameStop, AMC, BlackBerry Ltd, Express Inc. and Koss Corp. would be limited to those looking to close their positions “due to the extraordinary volatility in the markets.” Robinhood Markets users reported that shares of GameStop and AMC were flagged as “not supported,” following a similar curtailing effort from Charles Schwab Corp.’s TD Ameritrade.

This feels like little more than a stopgap move, and whether it’s good or bad likely depends on who you ask. The stock-pumping from vocal Reddit users, in some ways, is just the flip side of “smash-and-grab” shorting by hedge funds and other influential investors. And it can be seen as raging against Wall Street and the establishment after sitting U.S. senators were accused of insider trading on Covid-19 information. Democratization of markets is a good thing in the long run, even if it creates outbursts like GameStop from time to time. Pinpointing short-squeeze targets isn’t the ideal way to greater wealth equality in America, but slamming the door on individual investors isn’t the answer, either.

If you still believe in efficient markets, call option prices will likely self-correct higher eventually to account for the risk of targeted melt-ups. But that won’t happen overnight. That leaves all of Wall Street eager for the next chapter of the GameStop saga, especially because it doesn’t look as if regulators have a way of getting involved in the fight.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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